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The Canary in the Coalmine

by Scott Minerd, CIO, Guggenheim Partners LLC

Early coal mines lacked ventilation systems, so miners brought caged canaries into new seams to detect the presence of methane and carbon monoxide. If a canary stopped singing – or worse, died – the mine would be evacuated until the dangerous gas buildup could be cleared. Other animals were tried for this purpose, but canaries have become recognized for their natural ability to detect small but potentially lethal concentrations of toxicity.

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The recent string of surprise downside moves in markets may be the canary in the coal mine for global investors. Ongoing monetary stimulus is leading to heightened volatility, and the bull market which has been in place since 2009 is becoming overextended. To recount some of the recent disturbing developments, Japanese equities, which have nearly doubled since November 2012, fell almost 10% in three days in late May, and have continued to fall in June. This price move of approximately five standard deviations was eerily similar to the collapse in gold that occurred in April of this year.

The 12% crash in the Dow Jones Utilities’ Average, which occurred within an hour of market open on May 23, 2013, was largely overlooked. Several technical explanations for the crash were put forth, and the index nearly recovered by the end of the day. Oddly, a parallel series of events played out in the Flash Crash on May 6, 2010. Fat fingers were blamed for the outsized sell orders that swamped the market in that technical downturn. Equities, though, subsequently sold off to the lows of that day and eventually moved lower, despite the technical explanation.

RECENT MARKET CRASHES

Crashes that occur in bull markets, irrespective of their causes, do not bode well for short-run performance. The damage from April’s gold crash could take months or years to consolidate and repair. Investors should be prepared for this type of price action in other markets, including high yield bonds and U.S. equities.

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