Brushwood is to forest fires as leverage is to financial crises

Two weeks ago, we wrote, "with US stocks up an incredible 79.5% from the March 9th, 2009 low, a pause or even a pullback is to be expected.  Our forecast for the S&P 500 for all of 2010 is only 8%, so reason enough to be cautious 4 ½ months into the year."  We're more annoyed than surprised that stocks gave up all the gains of the year in following 10 trading days.  There still remain structural flaws in how the US stock markets currently operate, which culminated in the single largest intra-day decline of the Dow in history.  Though US markets closed well off the lows, the average investor was reminded once again of how the odds are stacked against them.  But if these same investors don't maintain a portion of their assets in the stock market, they won't be able to retire!
Judging from the e-mails and phone calls we received this week, the specter the September 2008-March 2009 crisis looms large in the minds of our clients.  In this letter, we'll discuss the role of leverage in pushing a conventional correction into a full-blown crisis.  We'll also talk about what caused the stock market to plummet almost 10% Thursday afternoon, only to bungee right back up 20 minutes later.

We often look to nature to explain the dynamics of financial markets.  Forest fires are naturally occurring phenomena throughout the American West.  Brushwood from dead trees accumulates over time providing fuel for a fire, which is often started by a lightning strike (occasionally by human carelessness, more rarely by an act of arson.)  Once started, a fire can cover thousands or even tens of thousands of acres before burning out naturally as the fuel supply is exhausted.  Years or even decades can pas before enough brushwood (fuel) accumulates to support another fire.

Read the entire commentary here.