What the Market Is Telling Us

After Feb. 27, volatility rules. Yet global capital also looks likely to flee riskier emerging markets and return to the relative safety of U.S. stocks

by Roben Farzad and David Henry

In the parlance of Thomas Friedman, the world never looked flatter than it did this week. A 9% stock market sell-off in China on Feb. 27 prompted sharp drops almost everywhere else around the globe. Suddenly, money managers and traders, lulled into a trance by seven months of steadily rising share prices, felt like they'd been hit over the head with a best-selling hardcover. With one big thwack, they were reminded that stocks are risky and that emerging markets are riskier.

In hindsight, no one should have been surprised. China surged an amazing 130% last year and 13% in the week ahead of the plunge, as millions of newbie day traders punched in buy orders on rumors about shares they'd never heard of. Stocks zoomed in other overseas markets for half a year; U.S. shares, which have lagged the rest of the world since 2000, rose steadily and with little volatility. Something had to give.

The question is what happens next. This latest episode of jitters could be the opening shock-and-awe campaign of something more lasting. The U.S. economy is suddenly looking weaker than it has in a long time. Fears are mounting that troubles in the mortgage market could spread to other sectors. And profit growth seems to be slowing markedly—a troublesome sign, to be sure.

But a stronger case can be made that Feb. 27 will turn out to be more of a tremor than an earthquake. Notably, U.S. indexes gained on Feb. 28. That's in part because powerful forces are undergirding stocks now in a way they weren't in earlier bear markets. The last bear came on the heels of a long bull market that included the biggest five-year run-up since the 1920s. Share prices are only now beginning to revisit their 2000 levels. The amount of cash sitting on the sidelines is at a record. Individual investors haven't jumped into the market en masse.

What's more, private equity is now a major factor. Buyout firms have raised billions in the past two years. Furious dealmaking is keeping asset prices buoyant and also cutting the supply of shares available to investors. That squeeze is being magnified by activist hedge funds, which are badgering companies into stock repurchases like never before. With the inventory of equities down and so much money already on the sidelines, the market appears to have a steady floor underfoot.

American Advantage

One thing is for sure: Volatility is back. Bulls and bears will battle it out over the next few weeks and months, not only in the U.S. but also abroad. That could actually be good news for U.S. stocks, at least relatively speaking. As fund managers and traders recalibrate their risk appetites, U.S. stocks stand to look more attractive than their overseas counterparts. In fact, the riskier those markets, the safer the U.S. will seem. In short, the world could seem a lot less flat—in a hurry.

The biggest support for the U.S. market has been, and will likely remain, private equity firms and hedge funds. The $45 billion privatization of utility TXU announced on Monday—the biggest of all time—was the second record-setting deal in three months. Eight of the top 10 LBOs in history have been inked since June; in 2006 alone some $420 billion in leveraged buyouts took place, a record. And yet private equity firms still wield as much as $2 trillion in combined buying power, enough to take out fully a 10th of the entire U.S. stock market.

The fuel for all the buying—low long-term interest rates—remains in the tank. In fact rates have been falling in the past few weeks and fell even more Tuesday, making the debt, or leverage, that private equity firms wield even cheaper. "The difference between cost of capital and return on equity is so enormous that if you're a leveraged player you just have to buy," says market watcher Jason D. Trennert of Strategas Research Partners. He goes so far as to suggest that the Standard & Poor's 500-stock index itself, if it could be packaged into a single entity, would be a screaming LBO candidate. Hence what veteran market strategist Edward E. Yardeni has taken to calling the "private equity put"—for put option, a floor price under a security. In this case it's under the whole market.