Sloan: Why Did Stocks Drop Last Week?

When I write about the stock market, I usually tell you to ignore the short-term noise and concentrate on the long-term picture. Today, however, I'd like to depart from form and talk with you about what we can learn from the past week's sharp declines in worldwide stock prices.

Let's start with $3.1 trillion. That's how much the market value of the world's stocks has dropped in the five trading days that ended yesterday, according to the folks at Wilshire Associates. Wilshire says $1 trillion of the loss comes from the drop in the U.S. market; the rest is from declines in the world's other markets. It works out to a drop of 6.6 percent, which is an awful lot for one trading week. And although owners of U.S. stocks have been whacked with a 5.5 percent decline, they're doing well compared with the rest of the world, which is down 7.4 percent.

The good news, of sorts, is that despite the $3 trillion-plus drop, the world's stocks were still worth about $44 trillion when the U.S. market closed yesterday—though by the time you read this, who knows?

One of the temptations of journalists—and supposed market experts—is to produce a valid-sounding, logical explanation for why all these markets have dropped. A number of reasons have been offered as to why these markets have dropped so far so fast: inflation; global economic slowdowns; fallout from the implosion of part of the U.S. mortgage market. But I have a more jaded—and I would say more realistic—view of things.

I think stocks are going down because they're going down, and that selling has begotten selling. Last year, so many stocks in so many markets went up so sharply because they were going up, and buying begat buying. As they say on Wall Street, "the trend is your friend." Except when it's your enemy.

Although I can't prove it, I think one reason why the markets are tanking en masse is that hedge funds are dumping stocks and commodities and currencies out of a combination of need and fear. Other hot-money trading shops—I won't call them investors, I'll call them speculators—are doing the same thing. These folks, in various parts of the world, aren't sitting around soberly contemplating the future economies of the United States, Japan or China. They're selling what they can.

This is the opposite of last year, when markets all over the world were rising, seemingly in lock step. If you didn't borrow heavily to buy stocks last year, you looked like a chump. Now, with markets dropping, having a lot of borrowed money is dangerous, and the players are bailing out.

The most obvious example is what is known as the carry trade, which involves the Japanese yen. For several years, you could borrow yen short-term for effective interest rates of about zero and invest in things like U.S. dollar securities that carried substantially higher interest rates. As a bonus, the yen was declining relative to the dollar, so you not only borrowed cheap and lent dear, you made a few bucks on the currency movements, too.

But not in the past five days, with the yen having risen more than 4 percent against the dollar. Suddenly, people who did the no-brainer yen-carry transactions are having their brains beaten in. Now, they're now scrambling to buy yen and sell dollars to unwind the trade. This pushes the yen's value up relative to the dollar. These currency moves have little or nothing to do with economic fundamentals; they're about trading.

You can see the results of the yen's appreciation in one stock: Toyota. Toyota shares trading on the Tokyo Stock Exchange have fallen 10.6 percent in yen the past five days, but Toyota shares trading on the New York Stock Exchange in dollars are down only 6.7 percent.

And now, a final irony. Just when you think you know what the market is doing, it turns around and does the opposite. It was on Feb. 20 that the U.S. market—as represented by the Dow Jones Wilshire 5000 Index — finally broke through the high that it set during the stock bubble in 2000. (The 30 Dow industrial stocks had set more than 30 highs since October—but although the Dow has huge mindshare, it's not the stock market.) Since setting its one and only high, the Wilshire has fallen more than 6 percent. Go figure.