Good Evening: The major U.S. stock market averages were all down more than 3% today, but after our markets suffered a harrowing afternoon plunge and rebound, most investors will take it. Market participants were already on edge before trading even began, with the recent riots in Greece providing the backdrop to a rapidly deteriorating financial situation in Europe. When the European Central Bank (ECB) gave no indication this morning that it would soon inflate the equivalent of monetary life rafts for the peripheral EU nations that threaten to sink into the Mediterranean Sea, the stage was set for a substantial decline in risk appetites. Our capital markets duly responded, as equities and commodities fell while Treasurys and the dollar rose. What happened during a sudden and heart-thumping swoon cum comeback in the afternoon is anything but clear. It could even have been some mistakenly entered trades, but what is clear is that the underlying problems have not gone away.

Markets in Asia and Europe were under pressure overnight as investors awaited news from both Greece and the ECB. The Greek Parliament actually voted in favor of the austerity measures that gave rise to the deadly unrest in Athens this week, but it was the press conference after the ECB meeting that saw some jaws drop (see below). ECB president, Jean-Claude Trichet, all but dashed the hopes of those who wanted to see the ECB hose down the solvency fires burning in southern Europe with the liquidity of Quantitative Easing. Not only did Trichet just say no to QE, he announced the ECB wasn’t even lowering its policy rate, at least for now. Perhaps he was just trying to be stoic, and maybe he was just trying to act as a responsible steward of the euro currency, but it is an understatement to say his (in)actions didn’t help.

The euro slumped to new lows and European stock markets followed suit. After two straight down days, U.S. investors apparently were hoping what was happening in Europe would stay in Europe. Our index futures were only down mildly prior to the open in New York. Prices leaked steadily once trading began in earnest, however, and the major averages were off some 3% by mid afternoon. It all made sense until stocks suffered what can only be described as a “mini-crash” and equally frantic rebound during the 45 minute period between 2:30 and 3:15 edt. Different media sources are blaming the hair-raising action on erroneous trades in certain equities and equity index futures (see below). I have friends who work at Citigroup, and I was told that the rumors were false — that Citi was not asleep at the switch that represents their electronic trading efforts.

Something, somewhere went wrong, though, and the NYSE and NASDAQ are investigating a series of what they thought looked like “erroneous trades” during the time period cited above. To pick just one example, P&G was trading roughly unchanged ($62) at 2:38 edt. Ten minutes later, it traded below $40, and just a few minutes after that it was back above $62. The media can call action like this “panic selling” all they want, but it looks to me like some mistakes were definitely made. Stocks like PG haven’t traded like they did today since the days surrounding October 19, 1987. THAT was a crash; today was not. Today’s trading did expose just how fragile our markets can be, however, especially when bids disappear and momentum-driven trading programs take over.

By day’s end, and after indexes like the Dow saw trading ranges approaching 10%, the averages finished with losses ranging from -3.2% (Dow) to -3.7% (Russell 2000). Treasurys were a highly sought alternative as risk aversion peaked this afternoon, and yields fell between 12 and 21 basis points. As 2010 dawned, I said periods of falling risk appetites should be used to reduce Treasury exposure. This is one of those times. The dollar rose a stout 0.75%, and commodities understandably tumbled in sympathy with stocks. Without nice rallies in gold and silver due to the flight from managed currencies the CRB index would have fallen more than the 2% it did today.

Nothing so spoils the digestion of a long and late lunch quite like returning to one’s desk to find the markets sporting gaping holes in their price charts. Before I could even ascertain what was happening, the market closed and I decided to go back about my business. After work, I did some digging, made some calls, and came to the conclusion that most of the worst of today’s move was a mistake. Does that mean investors should buy with both fists tomorrow? No, though I think stocks could enjoy a nice snapback rally in the coming days. Nimble traders might chase the to and fro volatility, but long term investors should ask themselves whether the underlying causes have been resolved.

At the moment, the issue is a funding crisis for certain countries in Europe, but the real issue is debt itself. Far too much of it was taken on during the late, great credit bubble, and it was a global phenomenon. What started in subprime, then spread to other mortgage products, crushed the GSEs and sent LEH to the NYSE symbol graveyard, was a process arrested in this country only when the Fed opened up its balance sheet and financed almost everything. By effectively shifting what had been private sector obligations onto the public balance sheets of the Fed and Treasury Department, what we really accomplished was changing who was responsible for paying back much of this stranded debt. The U.K. did the same thing, and both nations monetized a hefty portion of these debt purchases. Nations in Europe can’t pull off the same trick because countries like Greece, Portugal, and Spain can’t print euros — only the ECB can do that.

The options open to these European nations are not good ones, and the investment implications vary with each path taken. Default, a reconstitution of the euro, and/or some QE/debt monetization by the ECB — none of them are optimal and all require various measures of pain. I think the best decision is to wait for some policy clarity out of Europe. Until that day comes, I’m quite content to keep some cash, own some stocks, have some hedges in place, and let the precious metals portion of the portfolio grow as other currencies tumble. The rally in gold, despite a rising dollar and despite falling commodity prices, may be telling us that the yellow metal is finally asserting itself as the world’s most desirable currency.

— Jack McHugh

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