Last Week’s Correction: Let’s Not Get Ahead of Ourselves

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Includes: DIA, QQQ, SPY
by: Markham Lee

Liquidity and credit fears caused the Dow to drop by 4.3% last week. As a result, some analysts/investors began to use the dreaded “R” word, other investors are panicked/wearily tallying up unrealized losses and I can’t even begin to count how many times I’ve been asked (online and off): “Should I sell off the stocks in my 401k/Brokerage Account/IRA, et al?"

Here is the straight story: two days aren’t indicative of a long-term pullback in the markets and/or an economic contraction. Whilst I’m not discounting the magnitude of last week’s drop, I think investors need to slow down a bit and put the situation in proper context:

1. Whilst investors who were overly bullish or prone to wearing rose-colored glasses may have been out of the loop on some of the data around credit and liquidity, the larger market has known about it all along, and nothing has significantly changed over the course of last week. Generally speaking, long-term market downturns don’t just “happen” there is always a trigger event (or a group of them) that starts the market tumbling, at this point, we have “fears” but we haven’t had an event yet. Without a major catalytic event to trigger a pullback, I don’t see a long-term market downturn (or a recession) just yet.

2. Thinking about the above, what would the catalytic event be? If I were to hazard a guess, it would multiple major LBOs falling apart due the inability to get funding, coupled with a rapid decline in consumer spending and bank lending losses continuing to accelerate for several quarters. However, this is a picture that will take a quarter or two to develop, as it’s not something that will just happen overnight. At the moment, we’re seeing the “threat” of those things occurring, but they haven’t actually happened yet.

3. The Dow and the S & P 500 were testing highs, during a time period where investors should’ve been more cautious, due to many of the concerns around credit, consumer spending, LBOs on shaky ground, nearly every bank reporting accelerating loan losses, etc. It’s not logical to believe that such a market is going to just keep going, when there are legitimate causes for concern out there. A pull back that lasts a couple of days, whilst investors get themselves into more comfortable positions/take some profits off the table, is to be expected.

4. For the Dow, we had the worst week in FIVE MONTHS and the market has been on a tear since February’s market correction, on a forward P/E basis the S & P 500 is at its lowest level since early April. In other words, we’ve been here before and the market rallied afterwards. Investor sentiment is such that dips in the market are seen as automatic buying opportunities, so once things settle down, investors come roaring back into the market.

5. Continuing along with the theme of Investor sentiment, it doesn’t take much for the bulls to declare that the “Bears are wrong”, the only requirement is for a company to receive a buyout premium or another firm turning in a strong earnings report to make many investors feel that the negative fundamentals either don’t matter or have magically disappeared. Even a negative earnings report from a company that is due for several more are seen as buying opportunities. We’re going to need something stronger than a two-day drop to break the backs of the Bulls, who are undoubtedly going to be yelling “Buy Opportunity” from the rooftops over the coming week.

6. Points, 3, 4 & 5 aren’t reasons not to worry; instead, its reason to believe that the eventual pullback will undoubtedly be most unpleasant as the more overextended things get, the nastier the eventual “snap back” will be. The credit bubble, which spans consumers and corporations, is indeed a problem; it’s not going away and when it pops, it’s going to impact consumer spending, stock buybacks, collateralized debt, investing/securitized debt, the corporate bond market and LBOs, just to name a few. In other words, market pullback and possible recession? Probably, but last week’s pullback isn’t an indicator that we’re there yet.

Instead of worrying about the last week’s market pullback, investors should ask themselves: “Am I invested solid stocks with long-term growth opportunities?” If the question is yes, then don’t worry about last week’s market performance. Investing is a marathon, not a sprint and if anything, the pullback probably created some buying opportunities for you. The short term as measured in days, weeks and even months doesn’t matter for long-term investors, as the focus should be on quarters, years and decades.

The smartest thing for investors to do right now is to gain an understanding of how their portfolios will be impacted by the eventual real pullback. Investors should also put some thought into what the catalytic events driving a market pullback will be. Once they understand the pullback scenarios and the impact on their portfolios, investors should hedge their bets accordingly and move forward with the knowledge that smart investors always make money.

Don’t worry about last week’s drop - your real concern should be around whether or not you’re going to be caught looking when the inevitable real pullback occurs.