March 2007
The recent plunge in the stock market woke many investors up from their complacent dreams and reminded them (once again) that the market can quickly take back what it has given. In one day $600 billion vanished as the U.S. stock market fell over 3% and wiped out the gains for the first two months of the year. While some of the damage to unprotected equity portfolios was repaired the next day, the market opened much weaker on the first day of March clearly demonstrating that volatility is back. Hold on because the bumpy ride we expected for the stock market in 2007 has begun.
That recent 3.5% one day "correction" (translation - a market decline) was actually a rare event in the U.S. stock market. Since 1951 a 3.5% or worse decline has only happened 33 out of 14,650 trading days or .2% of the time. I have to admit that I must be jaded by past market experiences because this event didn't even raise my pulse. Then again my wife has complained that it takes more to get me excited than it use to. Maybe Jason's right, I am getting old.
The fact is when you consider that the U.S. stock markets had just enjoyed eight consecutive months of monthly gains (the longest streak in 10 years) and almost made it through a ninth month, a correction was long overdue. The S&P 500 Index had climbed almost 20% since the last shakeout in May without looking back. In addition, let's not forget that this stock market was up about 88% from its low in October 2002 with almost 4 1/2 straight years of positive returns. So what's the big deal about a 3.5% decline?
The big deal is that it is a reminder that the stock market is risky. People have and will continue to lose money in the market because they don't plan for those unexpected corrections or even worse the eventual bear market.
Like in these recent years, investors tend to get lulled into a false sense of security after a certain amount of time goes by and the markets only seem to go up. More and more of their money is put into riskier and riskier investments seeking higher and higher returns.
For example, over the past year individual investors have been placing most of their money in foreign equity funds, especially emerging market funds. One only has to look at the humungous returns from the Chinese, Indian, and the Russian stock markets over the past few years to understand the attraction. Our only question is do these people understand the risks? These stock markets can fall by 10% or more in a blink of an eye.
As with all corrections, this latest one in the global stock markets happened for reasons that are still not clear. Jason and I would not pretend to tell you why it occurred except to say the market was high and most people were looking for it to go higher. (We tend to be contrarians.)
We are always amused listening to the pundits on CNBC trying to rationalize irrational behavior. Some of these experts blamed the decline on the growing worries about the rising defaults in the sub-prime mortgage market. If that was the reason then why didn't the market react weeks ago when this news first came out?
Some others suggest it was because of the liquidity drying up as foreigners sold U.S. stocks because of the weakening dollar. It was even suggested that the assassination attempt on Vice President Cheney in Afghanistan was the explanation but we figured with his extremely low approval ratings the market would have rallied on that news... Just kidding.
The point is it is usually a wide variety of disjointed things that come together to scare investors and turn buyers into sellers. The common factor is that it almost always happens when people have lowered their guard and are enjoying the "easy money" returns the markets have provided. As we have said before, complacency can be hazardous to your wealth.
The question most people have is this a "buy the dip" opportunity or the beginning of a more extended and painful decline. Based on the recovery in the market on March 1st we would say there are obviously still a lot of people ready and willing to buy when given any good economic news. However, the wakeup call to risk has investors less complacent for now and a little more anxious. Selling pressure could bring the market down in a moment.
We still think there is strong demand for stocks from private equity funds and from companies either acquiring their competitors or repurchasing their own shares with their excess cash. These kinds of buyers place at least a temporary floor under the market as they stand ready to scoop up stocks or entire companies that they think are cheap. They will do this, however, only until they decide that the returns from such investments aren't worth it. A recession or higher interest rates could make that happen.
Most individual investors in the stock market will probably make very few changes in their portfolio based on these recent events even if their past complacency has led them to venture into investments that may not actually be appropriate for their age and financial position. Why should they? The market will eventually go up, right? It might. But what if it doesn't?
The economy is slowing and we think the risks are rising for a mild recession later in the year. At the same time labor and other costs are rising for most companies. Such a scenario would cause profit margins to shrink and make the market look more expensive at its current level. Thus, there are still reasons to be concerned.
We get paid by our clients to worry about risk and I would say from the rapidly expanding number of gray hairs on my head that we do it very well. We worry because we believe our primary responsibility is to try to limit losses when financial markets fall. That strategy leaves our clients with more money to invest at the market bottoms and the opportunity to witness the awesome power that the compounding of returns can have on those funds when the new stock market rally begins.
Our defensive strategy using put options and asset allocation has cushioned the effects of recent market corrections and would prove even more effective in a serious decline. Maybe that is why my pulse remained steady through it all.
John W. Gudritz, CFA
john@frontstreet.com