During the week of August 7, 2011, the Dow Jones Industrial Average either dropped or soared by 400-plus points per day for four consecutive days. Stock markets worldwide seemed to be trying to discount the downgrade of the U.S. government's credit rating, the political dysfunction leading up to the U.S. government's usually routine hike of its debt ceiling, and the increasingly prickly European sovereign debt issues and the challenge they pose to the European Union. Markets seemed like a proxy for a referendum on economic policy solutions supported by two schools of economic thought: those of John Maynard Keynes versus Friedrich August Hayek's. Here's what my sources told me as one of the most volatile weeks ever was ending:

Tom Connelly, who readers of The Gluck Report know has proved prescient repeatedly over the years, says the extraordinary increase in volatility is to be expected in a period characterized by high debt and deleveraging.

"That's still the backdrop, and it will be for some time," says Connelly, owner of Versant Capital Management in Phoenix.
Connelly believes the steps taken by the Federal Reserve and U.S. Treasury in the darkest days of the financial crisis in September 2008 deserve to be praised. Expanding the money supply and guaranteeing the solvency of too-big-to-fail banks like Citicorp, Bank of America and other institutions, saved the nation and the world from a calamity far worse. If the Fed and Treasury Department had not acted swiftly, says Connelly, "the whole financial system would have collapsed."
While praising government intervention at the peak of the crisis, Connelly argues against increasing federal spending to stimulate the economy now.

"I don't think Keynes would say you should stimulate the economy at times of financial distress," says Connelly. "Trying to execute Keynesian economics after financing two wars when you are running a big deficit is a bad idea."

Connelly believes the nation's largest banking institutions wield too much power. "I'm on board with the libertarians on this, and I believe the big banks should be broken up," says Connelly. "The banks pretty much own the White House. The Obama administration is doing whatever the bankers want them to do."

"I'm a Volckerite," says Connelly, referring to the former Fed chairman's stance on too-big-to fail banks, adding, "As things stand now, if one of the large banks fails, they'll all fail." Connelly favors enacting a modern-day version of the Glass-Steagall Act "to separate the circulatory system of the economy from depository institutions."

Connelly says he was initially embarrassed by the bickering in Congress over the debt ceiling. However, he has come to view the political discord as an ugly consequence of the U.S. democratic process and, as such, a step in the right direction. That, along with the public debate sparked by the Standard & Poor's downgrade, "has made the drumbeat for real solutions louder."

"I'm cautiously optimistic," says Connelly, 56.

Acknowledging that cutting government spending is inarguably deflationary and will result in dampening economic growth, Connelly nonetheless concedes it's necessary. But he sees hope in the fact that these issues were put on display in the run-up to the debt ceiling agreement and the downgrade of America's credit.

"I thought it was hopeless 12 months ago, so it was actually extremely positive that they came to an agreement on the debt ceiling," says Connelly, "not because the Tea Party and Republicans got their way, but because our elected officials are finally saying, 'Enough is enough.' They seem to have started to say 'No' to spending our grandkids' money."

Connelly says the safest place for assets right now is American corporations with strong balance sheets.

Gold remains attractive because it provides an alternative currency to the yen, euro and dollar. "Gold cannot be printed by a central bank," he says.

Emerging market stocks, particularly in East European companies, are attractive to Connelly. He says Eastern European governments "took their medicine." Austere spending policies recommended by the International Monetary Fund are working.

Muni bonds also provide unexpected value to advisors with good credit analysts. Bonds backed by fiscally responsible state or local governments, or their agencies, offer safety and yield. "It could be a county or a school district," he says.

Connelly says an issuer that is managed responsibly and can pay its debt with some cushion is attractive. If a muni bond shopper evaluates the underlying economy backing an issuer and examines the issuer's revenue coverage and expenses, he can find bargains-because in these troubled times, all muni issuers are being tarred with the same brush.

Connelly, incidentally, neither seeks the limelight nor is comfortable in it. At least three times during a 45-minute call, he recommended others who know much more. Indeed, experts in munis, economic policy and the European Union can be found. But Connelly is great at the worldview-understanding the overall picture and the most likely outcomes.

He says he's not sure what to do about Europe. He thinks Greece is sure to default; it's just a matter of when. Greece, Portugal and Ireland might need to be tossed from the European Union to keep it solvent. Since the Italian government in mid-August passed serious spending cuts, the Spaniards must make a similar effort, and then the EU can close ranks.
Connelly doubts European prospects without this level of commitment, discipline and action. The Italians and Spanish guarantee more than 30% of the recently adopted lending facility currently in place. "That's like lashing the Andrea Doria to the Titanic," he says.

Chris Petruzzi says the Fed and Treasury Department action during the crescendo of the September 2008 crisis altered the course of history by saving the giant banks. "If Obama and Bernanke would have done nothing, a lot of people would have lost their homes," says Petruzzi. "But after a year, it would have been over. We would have hit bottom in 2009 if they had done nothing."

Petruzzi says the economic model described by the Austrian school fits these times well. "The Austrian model begins with monetary authorities making interest rates too low, and investments get made that should not be made, says Petruzzi. "The resulting recession or depression is the correction that sets the economy straight.

"We made interest rates too low, buildings were built that should never have been," he says. "The problem is we stopped the correction from coming."

One of the thought leaders of the Austrian school of economics was Friedrich Hayek, who won the Nobel prize for economics in 1974. Hayek, known for his defense of free-market capitalism, was a contemporary of John Maynard Keynes, a British economist who advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions. Their philosophical and political differences form the intellectual backdrop to the current debates about the global financial crisis and how to approach it.

Petruzzi, a tenured professor in the School of Business and Economics at California State University, Fullerton, developed one of the first systems to profitably trade Nasdaq stocks with full automation. In the 1980s, Petruzzi was the sole proprietor of ECON Investment Software, developing risk management software for mutual funds, and the same system today is used by nearly 100 of the largest financial institutions in the U.S. He also developed the first arbitrage pricing theory software to operate on a personal computer, which is now used in 65 major financial institutions.

Petruzzi's current firm, Smart Execution LLC, for four years accounted for 4% of the total volume of the Nasdaq, with an average trading volume of 60 million shares per day. "We would buy at bid, sell at ask and pick up the spread and get rebates from the exchanges," he says. At Smart Execution, he developed a consistently profitable automated trading system that averaged more than $100 billion in annual transactions from 2001 to 2007. He is currently taking a leave of absence from teaching to develop patents related to automated trading and fraud protection.

Petruzzi believes the current economic environment fits well with the Austrian Business Cycle Theory (ABCT), which seeks to explain business cycles based on ideas of the Austrian School of Economics. The ABCT, according to Wikipedia, "views business cycles as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.

Petruzzi likens the market's need to allow only the most fit to survive to natural events, such as a forest fire. In hiking Sequoia National Park, Petruzzi says, he learned that the federal government had for years tried to stop forest fires from burning down the giant sequoia trees. Eventually, authorities learned that intervening was "unproductive," says Petruzzi. "Fires burned down old trees and, as a consequence, new trees spring up from the ashes."

Similarly, the government should have allowed weak institutions to fail. "That would have freed resources up," says Petruzzi. "Instead, people are afraid of putting in new money into these institutions." Homes that should be foreclosed on are left lingering on the market, for example, and people fear investing in real estate because they know it has not hit bottom.
"We would have had sounder banking minds running the banks," says Petruzzi, if Citibank and other weak institutions had been left to fail. "We needed to let it go bust."

Before the Federal Reserve was created, Petruzzi says, recessions usually lasted no more than a year, and depressions not more than two years. "We have taken these calamities and stretched them out."

Rex Macey says the fear gripping markets is "great for advisors." "In the late 1990s, individual investors thought they could buy tech stocks and get rich," says Macey, chief investment strategist at Wilmington Trust. "Now investors want professional advice."

Macey says the survival instinct is driving the markets. Panic selling is a flight from danger, and that's why investors headed to cash. "This is when investment professionals who understand markets and their tendency to overreact can lead clients to be more disciplined," he says.

Macey, a chartered financial analyst and certified investment management consultant, notes that during the waves of selling stocks, prices dropped low enough for the yield on the S&P 500 to exceed the yield on a ten-year U.S. Treasury note-which, he says, has happened only one other time since the 1950s and that was in the dark days of 2008.

Macey compares the struggle to maintain the European Union to America's Civil War. "The U.S. almost was split," he says. He says the German government will ultimately recognize that it should for its own self-interest foot the bill to subsidize Greece and other weak EU economies.

He says the stronger European countries have no choice but to fund a solution because cross-holdings among large European banks that have invested in each other's deals would cause a cascade of failures. "Ultimately, whatever needs to be done, will be. But it will be a period of angst because no one will step up until the last minute."

"You don't need to make sure everyone who owns Greek debt gets paid off," says Macey. "But you need to make sure the big European banks do not fail. If you let banks fail, you won't have an economic system anymore."

Macey says stock markets have overrated the likelihood of such a calamity. While disaster is a potential outcome, the stock market has priced it as though it is the most likely outcome when it is only a possibility.

He says advisors must address the panic selling and the investor flight with one of two answers for their clients: The clients need to stay in the stock market as a long-term strategic plan or should withdraw temporarily while at the same time defining an explicit re-entry point.

"If you are going to get out, you need a discipline for getting back in," Macey says. "We've introduced a dynamic allocation in which, as the stock market goes down, an investor decreases exposure. And when it goes up, you get back in." By defining a re-entry point, you satisfy the client's need to protect himself from the downside, but the client agrees to a re-entry point in an effort to avoid missing out on a major rally."

Tony Davidow, a member of the board of directors of the Investment Management Consultant's Association (IMCA) and a managing director and portfolio strategist at Rydex/SGI, says markets are more vulnerable than ever to swings like the one in mid-August. With markets around the world so interconnected and the flow of information so readily available to investors, Davidow says markets are more prone to volatility in response to dramatic events like the U.S. credit downgrade.

Davidow, a 25-year veteran of the financial services business, recalls his experience as an analyst working on the floor of the American Stock Exchange during the stock market crash in October 1987. "One of the older gentleman working on the floor said to me, 'You're lucky, you're getting your crash out of the way,' because he thought a [market crash] was a once-in-a-lifetime event." Since then, Davidow points out, the market has taken steep falls in 1994, 1998, 2000, 2008 and again in recent weeks.

Davidow says Rydex, like other fund companies, saw investors dumping stocks in the mid-August selling frenzy. "Individual investors have a history of doing the wrong thing at the wrong time," he says. "If history is any indication, they will return to the market after it has already enjoyed a good run-up. By the time they re-enter the market, they will have lost out on gains."

In times like these, Davidow says, some advisors question whether modern portfolio theory is dead and if traditional notions about asset allocation and diversification still work. While he concedes no one can know, he says, "The market looks good from here. The U.S. is the best house in a bad neighborhood."

To buffer volatility, Davidow says advisors are increasingly looking at alternative investments. He mentions Rydex's currency-based exchange-traded trusts, which give portfolios exposure to the euro, dollar, yen and six other major currencies.

Davidow says currencies have historically exhibited a low correlation to traditional exposures such as equity and fixed income, complementing traditional asset classes to dampen a portfolio's volatility. According to a recent research report by Davidow, many currencies have served as a hedge to equities and fixed income because of their low correlation. Over the past five years, as of March 31,2011, a basket of currencies, represented by the U.S. Dollar Index, exhibited a -0.56 correlation to equities, and a -0.41 correlation to fixed income.

Editor-at-large Andrew Gluck, a veteran financial writer, owns Advisor Products Inc., a marketing technology company serving 1,800 advisory firms.