What To Do When the Market Goes Down

With the S&P down 2.7% on Friday, I figured it'd be a good time to jump in again with a note about what to do when the market goes down.

First I'll note that if you're reading this blog, I'm assuming that you take a long term view to the markets, i.e. you are not a swing trader, day trader, or really any type of trader.

That said, the thing to remember is that market declines are just part of investing. If you're caring for a flowering plant, you get to enjoy the beauty of the flowers while they're around. After a while, the flowers inevitably die off. Instead of freaking out that the flowers are dead and digging up the plant, the good gardener will pinch off the dead flowers, knowing that the plant needs some period of dormancy to recharge, grow, and hopefully produce an even more impressive display the next time.

Hope I didn't lose you there (I love the analogies). Anyway, the point is that this isn't the time to chuck all your stocks and give up on investing.

Last I checked, the S&P, Dow, and Nasdaq are down 7.9%, 6.7%, and 7.8%, respectively, from their highs for the year. Ideally, I'd like to see the market ease even a little more before I got interested in a big shopping trip. The way it looks right now, it seems very possible that I will get that.

In any case, the thing to be doing now is reviewing your watch list and picking out your favorite stocks from there. If the market continues to slide, it's the perfect time to swoop in on some of those stocks that you really like, but just thought were a little too pricey. While stocks like Home Depot (HD) or USG (USG) have exposure to the housing market and may take more time to recover, if other high quality stocks like a Coach (COH), Coca-Cola (KO), or Johnson and Johnson (JNJ) sag with the market it could present a good buying opportunity.

Also don't forget to keep an eye on the stocks you already own. A market decline is also a good time to buy more of a stock you already own if it gets cheaper.

And if you need a reminder on why you stay in the market, be sure to take a look at a long term chart of the S&P 500.

As you look at the chart, you can notice the downward blips where the market declined, but the big picture is that on the whole the line continues moving up and to the right.

Disclosure: Average Joe owns USG stock in his personal portfolio.

Comments

[DeeplyConcerned]

"Cash is king when there's blood in the streets (or at the bottom of a major bear market decline)."

I'm sorry but I can't resist responding to the "dips are a good buying opportunity" comments -- mainly because I'm extremely concerned about the market right now. I would welcome other comments and perspectives.

As shown in the long-term chart of the S&P 500, there were several sharp declines (1966, 1970, 1974, 1978, 1980) but no significant cumulative increase in the S&P 500 from 1966 until 1981 -- basically a period of 15 years in a trading range. If you were invested in 1966 (and stayed invested until 1981), you lost a substantial chunk of your capital (in real terms) because those 15 years experienced substantial inflation.

The great bull market that started in 1949 had a major top in 1966 and a second major top in 1974 (based on extremely narrow breadth from the "Nifty Fifty"). In 1975, about 95% of small investors had cashed out their greatly-reduced investment accounts, and most of those persons who got burned badly never returned to the stock market.

Rather than being a good "buying opportunity" over the next few months, I have major concerns that 2007 and 2008 will resemble 1974 and 1975. No disrespect intended, but in good times after a 25-year bull market, it's easy to say that you're a "buy-and-hold investor" and "buying the dips is always a good approach" and "it's not timing the market but time in the market that matters."

Those who believe that markets always go up, except for brief short-term corrections, are naive and don't understand all the risks of investing in stocks. History has demonstrated many times that long-term bull markets end badly. After the majority of small investors lose 50% of their investment funds, there is usually a period of 10-20 years where stocks are avoided like the plague by small investors. Average profits continue to increase over time, and the average P/E ratio drops to mid-single digits, reflecting how out of favor stocks have become. This provides the basis for the next great bull market.

The great baby boom bull market started in 1982. It made a huge, speculative top in January 2000, but I do not believe it ended in early 2000 and a new bull market started in March 2003 (the valuations were still much too high). My major fear is that it made a second major top on July 16, 2007 which will be viewed with hindsight as the official end of this great bull market. If so, we're all in for a world of hurt over the next 12-18 months.