Market volatility returned with a vengeance in the third quarter. On Monday, August 24, the Dow Jones Industrial Average fell over 1,000 points in the first few minutes of trading. Why? Phil Nelson used to say that the market is an answer looking for a question. The media feels obligated to supply us with the question at all times and it would not make for dramatic headlines if the story line read “Markets Fall. Nobody Knows Why.” The drop in stock prices has been ascribed to economic weakness in China. We find this absurd. China’s economy has been weakening for more than 18 months. The cover article of the January 25, 2014 edition of The Economist reminded us of this fact with the title, “China Loses Its Allure.” The article observed that China saw 7.7% GDP growth in 2013, but points out the simultaneous disappointing manufacturing numbers and other signs of economic deterioration.

China has transitioned from an emerging economy to the world’s second largest economy after the US. Today, China’s GDP (if we can believe the data) shows total annual production of $10.4 trillion. China’s economy has grown between 7 and 14% annually for 20 years. As China becomes a bigger share of the world’s total economy, its growth will have to begin approaching that of the entire globe, which today is growing at about 2.5% annually. Slowing growth in China is not so much disastrous as inevitable.

Bespoke Advisors reported that the S&P 500 Index drop in late August caused a four standard deviation move from its 50-day moving average. They pointed out that the last time this occurred was on May 15, 1940. Few are alive today who recall that this was the Wednesday following the May 10th advance by German Panzer divisions through the Ardennes forest into France, which was regarded as the start of real combat in World War II. Do we really think that China’s economy slowing will be as devastating as the human catastrophe and economic dislocation caused by the Second World War? We do not.

So what is causing such volatility? Declining profit from trading, significantly increased regulation, and the conversion of nearly all of the large brokerage firms into banks during the 2008 financial crisis have resulted in a capital market that is not structured to handle large trading imbalances. Prior to the May Day deregulation on May 1, 1975, all brokerage commissions were fixed by regulators. As a percent of the value of each trade, brokers earned commissions of around 1%. Since then, discount brokers and computerized trading efficiencies have reduced this trading cost to a small fraction of a percent. Before 2008, the major brokerage firms such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns, to name a few, had large staffs dedicated to institutional trading. In addition, many of these firms also had separate departments with billions of dollars devoted to taking large positions for their firms’ accounts, called “proprietary trading desks.” If the institutional traders could not move the large stock blocks without driving prices up or down, often the firm would step in and take the other side of the trade, buying or selling the position at or near the current market price.

Lehman Brothers declared bankruptcy on September 15, 2008, Bear Stearns was bought and buried in JP Morgan, Merrill Lynch is now a division of Bank of America and both Goldman Sachs and Morgan Stanley have adopted bank charters. The Dodd-Frank Act forced all of these firms out of the proprietary trading business.

High-frequency trading and electronic markets have exacerbated the problem further, such that when there is a trade imbalance, market prices move very significantly until a balance between buy and sell orders is achieved.

While we do not subscribe to the “China argument,” neither are we sanguine about the state of the economy. The rise in real estate and stock prices since the 2009 lows has been driven by the near-negative real interest rates that the Federal Reserve has maintained for the last seven years. Instead of raising rates at the September meeting as the market had expected, the Fed ultimately got cold feet and left rates unchanged, expressing concern that “recent global economic and financial developments” (a.k.a. China) might put pressure on inflation. As Albert Einstein once said, “the definition of insanity is doing the same thing over and over and expecting a different result.” So why does the Fed persist in keeping rates so low? The short answer is that if the world does not build up a significant inflationary force, then sovereign default will occur and there will be hell to pay. That hell is called deflation.

Although service price inflation is up, commodity price inflation is flat to down. The latter has kept the consumer price index (CPI) and personal consumption expenditure (PCE) below targets. Global governmental spending to support commodity production (grain in the US, cement in China, lumber in Canada, etc.) causes excess production. This keeps prices down while boosting employment, which should ultimately lead to economic growth. But government spending also causes sovereign debt to continue to rise. What happens if the sovereign debt issued does not boost a country’s GDP enough for it to be paid back? The country has two options: default on the debt or devalue the country’s currency. (Please let us know if you would like us to resend you the May 25, 2010 article on this topic.) This is the larger structural issue that we believe could pose a greater threat to global economic growth.

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