The correction mentality makes for markets prone to overreaction.
Widely fretted Tuesday, bank demand for ECB debt was below expectations Wednesday, signaling European banks may be more liquid than widely believed.
Similarly a source of uncertainty, Washington's financial regulation bill was further watered down and final approval delayed until after the July 4th recess.
Investors may continue cycling and recycling correction worries, but at some point, they'll likely accept market-stopping events aren't happening as televised.
Correction fears have knocked stocks time and again this year. There's almost always some reason to worry even when stocks are charging straight up (which rarely happens). But in a correction, investors seem to act on an "all else equal" clause—if nothing changes, these concerns may become the beasts we fear.
But of course, markets are nowhere near static. They're dynamic, self-adjusting systems. Even our propensity to worry performs an important systemic service. Fear and speculation range ahead and note what "could be"—reducing the probability most times that widespread concerns ever turn out as nasty as feared. It's the risks most folks can't see that tend to blow up in our faces.
All this makes for markets prone to overreaction in the near term. For example, a major fear driving global stocks sharply lower Tuesday appeared less threatening Wednesday. In a European Central Bank auction, banks requested only €132 billion in 3-month cash ahead of Thursday's expiration of €442 billion in 12-month emergency funds. Bank demand was below expectations—which ranged up to €250 billion—and signaled European banks may be more liquid than widely believed.
Regulatory uncertainty can overshoot too. The thorniest issues are often defanged by debate and negotiation. Even as it seemed poised for approval, Washington's financial regulation bill was further watered down late Tuesday night. Congress hoped to pass last week's reconciled bill this week. But evidently, it ain't over till it's over. The law was on thin ice in the Senate already, and would have squeaked by with 60 votes. But when 51-year Senate veteran, Robert Byrd, passed away Monday, the bill's supporters lost a key Senate vote.
Negotiators were forced to scrap a last-minute punitive $19 billion bank tax inserted during reconciliation to pay for the bill's costs. The law may now be funded by moderately upping FDIC fees on big banks and wrapping up the TARP authority earlier than planned. The canceled bank tax is the latest in a long line of moderating moves. Previously discussed details since watered down or tabled include:
- No bank tax
- No break-up of large financial institutions
- No cap on size of financial institutions (although the bill calls for a "study" on this)
- Banks can maintain most of their derivative business in-house
- Capitalization, liquidity, and asset weighting rules will be left up to regulators
- Banks can still invest in private equity and hedge funds, on a limited basis
- Banks needn't maintain exposure to securitized agency securities—the largest component of the structured debt market
The House may vote Wednesday, but the Senate vote appears delayed until after the July 4th recess. Though it still seems likely the legislation passes, the final bill will be in a much watered-down, more favorable form than feared.
Investors may continue cycling and recycling correction worries, but at some point, they'll likely recognize market-stopping events simply aren't happening as televised. It's the very nature of corrections to turn on a dime at some unexpected point, whipping prices higher as fast as they brought them down.