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Uncertainty around the world is spreading fear in the markets. Will Greece default? In and of itself, Greece is fairly small but the fear of contagion is real. How will any default affect Portugal, Ireland, Italy, Spain or worse, the unintended consequences yet unknown?

There is plenty of uncertainty to go around in the USA. The SEC delayed Dodd-Frank derivative measures scheduled to take effect in July. Unemployment is on the rise again. The US 14.3 trillion dollar debt limit must be raised by August 2, yes trillion; a number so large most cannot fathom what it means. Most don’t think default is a possibility but as the drop dead date approaches with no resolution, fear could spread throughout the markets.

Recent history could serve as a guide. The following table shows NASDAQ performance during the internet bubble of 2000:

Date

Close

Point Drop

% Change

3/31/2000

4572.83

-

-

4/14/2000

3321.29

902.39

-19.7

On 4/14/2000 the one day drop was 9.7%. The NASDAQ went on to hit 1114.11 on 10/9/2002.

Fast forward to the recent financial crisis of 2008:

Date

Close

Point Drop

% Change

9/26/2008

2183.34

-

-

10/22/2008

1615.75

567.59

-26.0

On 9/29/2008 the one day drop was 9.1%. The Dow suffered single day drops in excess of 7% during the same period.

We would be remiss if we did not mention the “Flash Crash” in 2010. From Wikipedia:

On May 6, US stock markets opened down and trended down most of the day on worries about the debt crisis in Greece. At 2:42 pm, with the Dow Jones down more than 300 points for the day, the equity market began to fall rapidly, dropping more than 600 points in 5 minutes for an almost 1000 point loss on the day by 2:47 pm. Twenty minutes later, by 3:07 pm, the market had regained most of the 600 point drop.

Yes, it could be worse than any recent down drafts. Those of us who had the good fortune of being in front of our computer screens on the days these downdrafts occurred can attest to the following:

  • Fundamentals are meaningless once fear and panic take hold.
  • Any metric to evaluate the depth of the crisis falls short, usually in a major way.
  • Fear is palpable.

Once panic enters the picture it’s like being caught in a raging river. As fear spreads many investors will abandon their plans showing a complete disregard for any long-term investing plan based on fundamentals. Those that are highly leveraged will be forced to sell as the market continues to decline, others will sell along the way as fear and panic take hold, fueling a vicious cycle to the bottom.

Why do investors panic? Benjamin Graham’s “The Intelligent Investor" updated with new commentary by Jason Zweig, explains how fear can affect judgment. This excerpt starts on page 220 (emphasis mine).

When stocks drop, that financial loss fires up your amygdale-the part of the brain that processes fear and anxiety and generates the famous “fight or flight” response that is common to all cornered animals. Just as you can’t keep our heart rate from rising if a fire alarm goes off, just as you can’t avoid flinching if a rattlesnake slithers onto your hiking path, you can’t help feeling fearful when stock prices are plunging.

In fact, the brilliant psychologists Daniel Kahneman and Amos Tversky have shown that the pain of financial loss is more than twice as intense as the pleasure of an equivalent gain. Making $1,000 on a stock feels great-but a $1000 loss wields an emotional wallop more than twice as powerful. Losing money is so painful that many people, terrified at the prospect of any further loss, sell out near the bottom or refuse to buy more.

We’ve yet to hit the point where fear becomes so pervasive any market drop defies logic but it’s happened before and history will repeat at some point. The trigger could be the gridlock in the US where leaders are either unable or unwilling to solve the spending and debt problems.

I don't think the US will default but as we approach the self-imposed political deadline of August 2 with no progress, fear will spread through the markets. Monday's markets may give us an answer with less than ten days left, and both sides seemingly deadlocked at the time of this writing. Rating agencies will continue with the downgrade threats or worse. The word "default" will be all over the news with ever more intensity as the date approaches.

Market corrections yield opportunities after allowing time for the sell-off to run its course. Companies with a history of solid cash flows and earnings will probably weather the storm better than companies with little or no track record, or those with high debt to equity ratios. I have no idea what will happen, but August 2 is approaching fast and it may pay to be cautious going forward.

Here is a sampling of companies we’ve written about on Seeking Alpha whose fundamentals may not change if the markets react negatively to the US debt problem. Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL) and Intel (NASDAQ:INTC) are large cap stocks with good track records of generating strong cash flows and earnings and low debt to equity ratios. Telular (NASDAQ:WRLS) is a small cap stock whose history for generating cash and earnings is more recent since new management was installed around 2008. It’s included here because the dividend is extremely attractive. Links to articles highlighting the fundamentals are in the table below. We track these stocks in normal times so any price drops not associated with the individual fundamentals could be an opportunity.

Stock

Updated fair value

Date first Published

Publish closing price

Recent Price

Dividend Yields

Instablog Link

Article Link

MSFT

$34

9/24/2010

$24.32

$27.50

2.33%

Link

Link

WRLS

$7.3

8/1/2010

$2.48

$6.26

6.39%

Link

Link

AAPL

442

3/14/2011

353.56

393.14

NA

Link

INTC

$28

4/6/2011

$19.79

$23.13

3.63%

Link

Conclusion:

I remain cautious until the debt crisis plays out. I have not been a buyer recently since there is a real possibility of a looming crisis within days. Pick stocks with strong fundamentals and stay the course if the fundamentals stay intact. Is there a correction coming? I don’t know, but it’s hard to imagine business as usual if no long term resolution on the debt crisis emerges.

Talking about buying during a correction is easier said than done. Stay in control of your emotions and base your trades (buy or sell) on sound investment decisions, not panic or fear. It is my sincere hope all parties will do whatever it takes to avoid any possibility that can be tied to any default scenario, but I'm not holding my breath.

Our SA record on individual stock writings can be found here.

Source: Market Correction on the Horizon? Use Caution Going Forward