The US Stock Market’s New Thrills

Tuesday, June 15, 2010

The US stock market continues to get into the record books. This time it’s the quick drop from April 26 to June 7, unmatched in the past 80 years except in 1950 when the Korean War broke out.

So, what’s going on? Is this the beginning of a new bear market? Or is there something unusual going on in the stock market?

The Wall Street Journal describes how professional analysts and investors are wrestling with those questions in “Rapid Declines Rattle Even Optimists” (Abreast of the Market, by E. S. Browning, June 14).  Here is the article’s key observation (highlighting is mine):

“A look at history confirms something many investors had felt about the market’s recent turmoil: It is the speed of the declines, even more than the size that has been most shocking.”

The professionals interviewed all point out that the characteristics of the drop are rare, as is the timing – immediately following a long, steady run-up. While they note that bull markets rarely turn into bear markets this quickly, their confidence has been lowered:

“The fact that the market has proved so fragile has made even some optimistic analysts wonder whether the troubles might be deeper than people had believed.”

“… the market’s vulnerability has left him [Tim Hayes, Ned Davis’s chief investment strategist] with doubts.”

Both “so fragile” and “vulnerability” are based on historical comparisons with “similar” times. The doubts arise because the drop is speedier, so something must be amiss – some fundamentals must be going wrong worse than thought. There is something amiss, but it’s not in the fundamentals – it’s in the stock market, itself.

The US stock market has new stripes

All those interviewed make comparisons to the past. However, that only works if the basic underpinnings and workings remain the same. The problem we now face is the US stock market has changed in two major ways:

  1. Weakened constraints and restraints – Important regulations that helped control the stock market’s volatility have been lessened
  2. Unregistered, loosely regulated investment pools – These sizable entities (think hedge funds and Wall Street trading departments) are able to take advantage of the less regulated stock market

(See my series, “Pitfalls in Today’s US Stock Market” – Part 1, Part 2 and Part 3)

Game playing can override fundamentals

When moneyed stock market “investors” are free to play with stock prices, investing takes on edgier, psychological game characteristics. Odd price movements can be accompanied by rumors and discussions of “they” putting the price up or down – just like in the 1920s and before.

This presents us with an odd situation – where “recent” history (post-Depression) can be detrimental to investing success and “ancient” history (pre-Depression) can be helpful.

The changes provide both an opportunity and a risk

The opportunity from wider ranging stock prices is the greater chance of buying low and selling high. The risk is the effect of a less rational, more emotionally charged atmosphere that can lead to greater uncertainty and investing mistakes.

This may sound like the perfect environment for short-term trading, but it will take an iron stomach to stay committed when those low prices get undercut significantly and quickly.

For the long-term investor, fundamentals will rule long-term results, so there should be an advantage. To stay committed, though, there needs to be less focus on short-term price moves and the fruitless search for the reasons why.

So… The change in the rules means stock prices can roam further from fundamentals. This volatility removes the historical comparison yardstick that we have been accustomed to using. Greater uncertainty is the result, but so, too, is the opportunity to buy or sell at desirable prices.

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