Stock Market Logic

 The End is Near

The stock market works on its own logic and smart people who apply normal logic to it do so at their own peril. Most people have been fearful about the market, despairing about the economy and disgusted with the government. So what did the market do? The Dow Jones Industrial Average rose more than 1,000 points in little over a week in early October. Did the outlook suddenly improve dramatically? Not at all. It’s true the world didn’t end. Most of the time it doesn’t.  In the ashes of bear markets and terrible recessions, great bull markets are born. The light at the end of the tunnel always seems a long way off but we get there at unexpected times and sometimes with surprising speed. Beneath the gloomy headlines, some positive news lurks. Major banks have reported strong lending for the first time in four years, the Federal budget deficit dropped $300 billion from the original estimates because of higher revenues and lower spending and it is expected to drop another $300 billion next year, according to the U.S. budget office. Eventually the economy will heal and employment will improve and the stock market will lead. No one knows when that will happen but it doesn’t pay to despair.

The Temptation to Panic

            The Most Dangerous Month of the Year

            August was the most dangerous month of the year for investors. That’s not because the world stock markets dropped precipitously. It’s not because of alternate drops and spikes of hundreds of points in the major averages. It’s because of the temptation to panic.
            None of us can control what happens to the world economy or the stock markets. What we can do is control our reaction to those events.
            We’ve all heard that investors alternate between greed and fear. But in relation to the stock market, what exactly does this mean?
            When the stock market starts to drop, investors tell themselves that it’s only temporary and they stand pat. But the sky continues to darken. The news gets bleaker and the problems begin to look intractable. Eventually the news is overwhelming. There is no way out. The economy will never recover. Our way of life is ending.
            The pressure keeps building and there is only one way out. The investor must sell. He must act before it is too late. And he does. He sells. He sells everything. He salvages a portion of his assets and he feels better. For a time. Perhaps a few days, maybe a few weeks. Enough of these seesaw markets. He can’t take the pressure but he doesn’t have to and he sells. Volume surges on the markets and the television shrieks more shrilly.
            But the satisfaction doesn’t last long. Strangely, for no apparent reason, the stock market slide comes to an end. Still, for no good reason, it spikes upward and keeps going. It’s strange. The problems are still there. The economy is still a mess. Our leaders have yet to don their superhero costumes. But there it is – the stock market races up and our investor is on the sidelines waiting for signs that the economy is improving and the market moves without him.
            I know it is not you. I know you would not panic or let greed drive you in a bull market. I know that even though “buy and hold investing” has become a dirty word, you stay the course.  I know this is just a function of cable television. But many other people did do this. Stock volume surged this August. Somebody was selling at low prices. Somebody was panicking. Someone was looking to end the pain.
            There is a book called “One Way Pockets: The Book of Books on Wall Street Speculation” by Don Guyon. It was written in 1917 by a broker who analyzed customer accounts. He found that they owned the right stocks but bought them too late in the bull market and waited too long into the bear market to sell. They owned the right stocks but still lost money.
            Investor behavior never changes. The headlines do, at least a little bit. At one point every year, the world is ending. What should an investor do?
            The advice doesn’t change either. Don’t try to outguess the markets. Have a plan for yourself and stick to it. Build a diversified portfolio. Determine a risk level that you can live with for the long haul. Keep your eye on the long-term and stay off the roller coaster.
            Don’t try to guess what will work. The hero of the last bear market was John Paulson. He is a hedge fund manager who was lionized in the book “The Best Trade Ever.” He made billions spotting the problems in the subprime mortgage market and acting on it. Recently Bloomberg reported that Paulson’s fund is down 34 percent for the year while the Dow Jones Industrial Average was down 1 percent.
            A study by JP Morgan Chase & Co. showed that mutual funds are trailing their benchmarks by the most since 1998. At the same time, Fidelity Investments studied their investors’ 401-Ks and found that those who exited stocks in the heart of the last bear market were up only 2 percent through the cycle while those who stayed in stocks were up 50 percent.
            The lessons are clear. Don’t take big bets and try to predict the market or the economy. Acting on your emotions does serious damage to investors year after year. Being an active trader may be exciting and it may seem like the thing to do but in the end cooler heads prevail. A sound, well balanced approach is the surest path to investment success year after year.