This Stock Market Decline Is Painful

Friday, July 2, 2010

It is agonizing and frightening to watch money disappear quickly. The stock market is notorious for periodically shaking the confidence of all investors. This week’s stock market downdraft is the perfect environment to create panicky feelings.

What’s an investor to do when the news is bad, advisers are predicting more to come and the stock market graph looks awful? Particularly when every bone in your body is yelling, “Sell!”

This week’s decline hit the pits of our stomachs. It has us questioning where we had gone wrong as the market seemingly searches for a new foundation. What does it mean? Well, actually, it’s a sign that the emotional level I mentioned in “The Lonely Art of Contrarian Investing” (June 7) has been reached:

Step 4. Listen to your emotions

The advice, “trust your gut,” works in reverse in investing. Every investor, no matter how experienced, has to deal with the same human emotions in an extreme market environment. When conditions fairly scream, “Buy! Money for the taking!” or “Sell! Big losses ahead!”, feelings of over-optimism (greed) and over-pessimism (fear) can take over. Experience can teach investors to use such feelings as indicators of the time to think contrarian. An experienced investment manager said it well:

“The best time to buy stocks is when you hear the term, ‘stock market,’ and you want to throw up.”

What I’ve learned from other rough stock markets

Throughout my investing and fund management experience, I have found that the best way to win in rocky markets is to stick to a well-designed investment strategy.

However, a market reversal does raise the question of whether the strategy is flawed and new information undermines the previous analysis. So, a market drop requires an audit.

  • Reexamine underlying facts. If conditions have shifted, a change in approach may be required. In investing, nothing is certain, so it is important to be willing to change if there is good reason to do so.
  • Review portfolio holdings. Starting with what is owned and why, a review can weed out weaker holdings as well as identify any special opportunities not held.

Note: Selling at a loss if a company isn’t measuring up is not a sign of poor investing. Predictions can go awry because stuff happens. However, selling a good position just because it has gone down can be a mistake, particularly when the market is dragging down most stocks.

  • Evaluate the investment environment. The more pessimism, with feelings of disaster ahead, the more confident we can be that emotions, not facts, are driving the market.

Where today’s stock market differs from history

Today, investors must contend with added, adverse trading activities in the stock market. Actions can now be used to heighten emotional selling, and I believe we are seeing that effect now.

Note: I covered these items in a 3-part series, “Pitfalls in Today’s US Stock Market” – May 25, 26 and 27. Part 1 and Part 2 discuss the problems. Part 3 describes what investors can do to avoid the pitfalls and even take advantage of them.

Unfortunately, the added volatility in today’s stock market means historically helpful measures (e.g., the 200-day moving average) are less useful. Trading tactics can take advantage of such “rules” to trigger selling at abnormally low prices.

Three upcoming hurdles

There are three “events” that should help settle the debate about the stock market’s appropriate level and direction.

  • Second quarter earnings reports (mainly, mid-July to mid-August)
  • Wall Street shift in focus to 2011 earnings estimates (early September)
  • Third quarter earnings reports (mainly, mid-October to mid-November)

There will also be economic and other reports that will influence investors. But the estimated earnings are Wall Street’s best window on what it all means – to the individual companies and, therefore, to the underlying values of our stockholdings.

So… This week’s decline is certainly painful. The question is how much of the drop is based on fact and how much on feelings. Starting in two weeks, we will begin getting companies’ earnings reports and outlooks. Those will be  followed by analysts adjusting their future earnings estimates. At that point, we will be able to make an informed evaluation of our holdings and the US stock market in general.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

July 2010