Stock markets around the world took big hits Friday: a 9 percent drop in Tokyo, 5 percent in London and 3.6 percent in New York. But investors seemed relieved that the Dow lost "only" 312 points.
So far this month, the global sell-off has erased $10 trillion from global stock values.
John Makin, chief economist for the hedge fund Caxton Associates, says the fundamental reason for the massive sell-off is investor fears that the U.S. and other countries around the world are entering a severe recession spawned by the global credit freeze.
Heading For A 'Sharp' Recession
"What we're seeing here is what I'd call a rolling and accelerating adverse feedback loop," says Makin. "The world is heading for a very sharp recession. That tends to feed back again on hurting credit markets more, which in turn can feed back and hurt the real economy more."
Makin thinks the U.S. recession will be deeper and longer than normal. He's expecting unemployment of around 8 percent and a shrinking economy through 2009.
David Kotok, chairman of Cumberland Advisors, a money management firm, expects a less-severe recession. The reason? The huge amounts of money that governments have poured into the financial system.
"History would show that when the government and its agencies and the central bank are massively stimulative, you get a shorter, shallower period and then you begin to improve," Kotok says.
Kotok believes the sharp market decline of the past few weeks is in large part a function of forced selling by hedge funds. He says hedge funds borrowed huge amounts to buy stock indexes and bought credit default swaps as insurance against potential losses.
But for many, that insurance disappeared with the collapse of Lehman Brothers, a counterpart to many of the swaps. So as the markets declined sharply, hedge funds had to sell those stocks to pay their debts and pay off investors pulling out of the funds.
"We saw $43 billion withdrawn from hedge funds in the month of September," says Kotok. "That doesn't represent $43 billion of sales — forced selling. That represents $43 billion of cash that exits."
The leverage on that cash might have been 10 or 20 times, he says. That means the value of stock that had to be sold was 10 or 20 times $43 billion.
But Kotok believes this kind of selling is peaking right now, and that it will leave U.S. stocks at levels that represent good values for investors.
Makin, the economist for Caxton Associates, isn't so sure.
"It's not a matter of whether you're called a hedge fund or whether you're called a pension fund; there's a rush for the exits here, which is tending to be self-reinforcing," says Makin.
He says normal price-to-earnings valuations aren't necessarily relevant in the current market, where even companies like General Motors are being priced with the possibility of bankruptcy in mind.