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A Wild Day in the Market; What’s Going On?

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The stock market is officially in a correction. Volatility has spiked higher and fear is gripping markets around the globe. Many large US companies are down 10% or more as the fundamentals improve. Wow! Yesterday was remarkable on many levels!

This dramatic one day market decline is not about individual stocks or fundamentals. The day began yesterday as a fairly typical down day. Then, about 2:30 Eastern time the markets collapsed into free fall. The Dow Jones industrial average lost 700 points in a matter of minutes. The initial fall was blamed on a trader who entered an order with too many zeros. This triggered program sales and then, so the story goes, computer errors caused stocks like Procter and Gamble to drop over $20.00 per share. It was a perfect storm and frightening to watch.

What does all this mean? The market opened down yesterday on fears Greece’s problems would spread and cause the European banks to freeze. Comparisons to the Lehman failure and the devastating impact this had on the US economy were alarming. What this tells us is that there is a still fear and uncertainty, even as investors as recently as two weeks ago piled into small, high beta, high risk stocks. Years ago we bought and sold stocks through a specialist who matched buyers and sellers. Today, trading is instantaneous even from mobile phones. Things can unravel very fast with a very decisive break in the market uptrend. Yesterday was an institutional day – retail investors were on the sidelines and didn’t create the volatility. The risk trade became a fear trade in a matter of minutes. Investors watching felt powerless!

What do you do on days like yesterday? The market bounced back yesterday to where the trading session started – down but not in crash territory. Fundamentals are improving and this kind of panic selling is painful but in hindsight it is almost always best to stand back and stay on the sidelines.

Is this market turmoil the sign of things to come – another 2008 market crash? There are many problems in the US economy and Europe is in crisis. Fear is that the Euro will collapse as a reserve currency and the European economy will stagnate. This leads to speculation US exports to Europe will decline.

The market is not likely to retreat to March 2009 levels. There are definite signs of recovery and US corporate balance sheets are strong. The key to success isn’t market timing or panic selling. A discipline approach to asset allocation is the only way to manage in markets driven by emotion and macro events. If investors trim stocks to their equity target when the market rallies like it has then there should be cash on hand to buy.

We have plenty to worry about. It would be a mistake to back up the truck now and buy indiscriminately and it would be equally wrong to sell all stocks and leave funds in cash yielding less than 1%. This decline could go on for awhile but this will lead to some very attractive opportunities. Stocks will swing between gains and losses as headlines drive emotions. Extreme uncertainty will cause fluctuations in price and high frequency trading is now 50% or more of trading volume. The only way to thrive in this environment is to take a longer term view and buy those stocks that offer dividends, good growth and stable earnings. Prices for stocks like Johnson & Johnson, Microsoft and Hewlett Packard are at very low levels compared to their growth, dividends and sound financials. The crazy market behavior and rumor driven trading will pass and over time these quality companies will reward investors. Profits today are good and improving with the economy.

The answer to “what to do” depends on investor attitudes toward risk. Unfortunately, when the market advances it is common to think only about returns and ignore what might happen when risk rears its ugly head. Yesterday was a reminder that things can unravel quickly. It is common for investors to raise stock targets at high levels and want to own less when the market is down. This emotional approach is costly and days like yesterday are painful. On the other hand, disciplined investors recently trimmed stocks as the market rose, are below their target stock weight and can take advantage of opportunities on crazy days like yesterday. The reaction to yesterday’s market says a lot about risk attitudes. Some reacted with “Wow! What great buying opportunities” while others panicked and wanted out. There isn’t a right answer. The emotional reaction becomes a good indicator for risk attitudes and can be used to determine a long term asset mix target.

The debt worries in Europe and in the US are real and should not be taken lightly and wild reactions to headlines will continue. Stocks are down over 10% in the past few weeks and 2-4% daily moves are common. The world today is confusing and issues are complicated and interrelated. Risk control and discipline are critical.