Why Markets Are So Shaky.(Global Investor)

Byline: Barton Biggs; Biggs, the famed Wall Street strategist, is now a hedgefund manager at Traxis Partners.

Since mid-July, equity and fixed-income markets across the world have endured sickening declines and startling volatility. Major financial institutions have suffered grievous wounds, and numerous lesser bodies have drifted to the surface belly-up. On Aug. 28, a beautiful, relatively rumorless, late summer day, the Dow Jones Industrial Average

abruptly collapsed 280 points,with the volume in falling stocks 10 times that of rising shares. Most of this rout came in the last two hours of trading. The next day there was a massive surge up of 247 points, again concentrated in the final hours. And so it has gone. The number of extreme days in the last six weeks is unprecedented, begging an explanation.

First, volatility breeds fear and therefore more volatility. The giant hedge funds and proprietary trading desks are run by people who, like us, are susceptible to fear and greed. Most are not particularly intellectual, analytical or studious. They rely on their intuitions, and their basic instinct is to buy when prices are rising and sell when they are falling. This is called "trend following" or momentum investing. Most computer-driven trading models are similarly programmed. In other words, selling begets more selling and vice versa.

Furthermore, the executives these hyperactive souls work for are very intolerant of losses -- drawdowns, in the lingo of the business. The clients of the hedge funds, particularly the funds of hedge funds, will yank their money if a fund has a couple of months of 3 to 4 percent declines in net asset value. The risk managers who run the trading desks at the big investment banks and brokers are even more trigger-happy. If a proprietary trader gets down 10 percent, he is likely to be closed down.

Conversely, when a decline abruptly changes into a rally, traders who sold into the decline are scared to death that they will miss the chance to make back their losses. A buying panic develops. This frenetic activity is rationalized by the participants' murmuring "the market acts well" when it's going up and that "it acts badly" when the beast is falling. Mutual-fund and pension managers are less frenetic but they also are under pressure to outperform their benchmarks. While holding cash is a sure benchmark beater in a down market, it is a millstone heavy burden in a rally.

There also is a huge amount of hedging going on using the S&P 500 Index and other indexes. When the subprime mortgage crisis first began, selling from fixed-income hedge funds and other bond funds scared the stock market and created weakness ...