When I wrote my book in 2003, Please Don’t Feed the Bears (your portfolio) I included a chapter on volatility in the markets. The quote in the chapter was the following: “I can predict the motion of Heavenly bodies but not the madness of crowds” --Isaac Newton. There is a provision in the SEC Act of 1934 to maintain a fair and orderly market for the investing public. There has been a failure of the regulatory authorities to forsee the carnage which is now prevalent, instead of taking some precautions in advance.

      Volatility is a result of too much leverage and too many hedge funds and traders short selling stocks, equivalent to “bear raids”. The amount of leveraged “bets” in the financial system is in the trillions of dollars.

      Let us look at past financial panics and relate those panics to the present one.

• October 19, 1987. The stock market crash on “Black Monday,” October 19, 1987 was the major event of the year when the Dow Jones Industrial Average fell 508.23 points. The Average closed at 1938.83 at year’s end, up 2.26% for 1987 but down 29% from the peak in August. The main culprit was program trading and portfolio insurance. I am not going to define these terms except to write that these were computer generated programs, highly risky, highly leveraged and eventually discarded as failed strategies.
• The second panic occurred in 1998. This involved the collapse of Long –Term Capital Management. In 1998 LTCM included two Nobel Prize winning economists, led by John Meriwether and was a $1.5 billion capitalized hedge fund and was leveraged to approximately one trillion dollars. The overuse of derivatives employing high powered computer programs resulted in the portfolio of LTCM to decline 52% for the year. On August 31, 1998, the Dow fell 512 points or 6.40% to 7530. This decline at that time was the second largest in history in point terms, trailing the 554 –point drop in October, 1987. Again, the use of derivatives and over speculation Caused a world wide panic.
• The third event happened on September 11, 2001 following the catastrophe of the World Trade Center. By the time the market reopened after the 9/11 terrorist attacks, the market fell 7%, or 684.81 points. The decline was caused by the terrible event but was also magnified by traders and shorts.
• This brings us to the present crisis. On Sept 15, 2008, the Dow Jones had dropped 504.48 points amid worries of the bankruptcy of Lehman and the sale of Merrill to Bank of America. We also have the imploding of AIG. Short sellers have magnified the decline of some stocks. Despite of a decent earnings report, Morgan Stanley declined from the low 40’s to a low of $15.00 on Sept 18, before closing near $22.00. The problem with Fannie and Freddie was lack of supervision and shoddy accounting. Two of the principals of these institutions retired with million dollar retirements and are now advising the Obama Campaign.

      Democrats had blocked a possible investigation of Fannie and Freddie. Again too many derivatives, too much debt and a lack of accountability created unbelievable leveraging that magnified the damage. The question is again, when will the financial regulators get a “handle” on derivatives that are often a huge problem when they become unmanageable and will concentraded short selling be reigned in ?

Gary E. Marsella

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