From Monday to Wednesday, the S&P declined 3% from 1080 to 1050, but by yesterday it had retraced half of the losses. Today we are off to a bad start once again. The first couple of days, there was general uncertainty as to what was causing the sell-off. Was it rumors that financials may need to raise more capital when the equity markets started to shut down? Was it that the tax bill with the 4-year instead of the current 2-year look-back seemed dead in the water? Was it the uncertainty surrounding the extension of the first-time homebuyer tax credit? Or was it position-closing by many mutual funds whose fiscal year ends in October? The market recovered on Thursday as GDP growth was higher than expected, but the market was disappointed after a decline in consumer spending reported early on Friday. The strong GDP growth should not have been unexpected, given the large stimulus provided by the government, and weaker spending made sense as some of the government programs ran their course.
The market has been particularly strong lately on the impact of government stimulus and apparently only needed an excuse for a correction. Fundamentally, there was no meaningful change in the quality and outlook of business from a week ago. The rumor that financials may need more capital came from a WSJ report that the government may ask Bank of America to raise more capital before it can repay TARP. Without a permanent CEO and inability to issue shares without shareholder approvals, this is not an immediate-term event, yet the market over-reacted. The tax bill has failed to pass many times before and it wouldn't have that much of an impact for businesses. The homebuyer tax credit was already agreed on in principle, but the market is sometimes too skeptical and over-discounts uncertainty (like it did with Citigroup's preferred exchange earlier this year).
Unfortunately, the market is extremely whimsical, perhaps because of day-traders and algorithms that take no account of fundamentals. A small miss on consensus or a technical trigger on a chart can cause massive sell-off and increases volatility. There are two ways to think about this. (1) It makes it very difficult for fundamental investors because they see their gains evaporate in a day or they have to endure a lot of pain before their thesis plays out; the whipsaws present the illusion of un-captured gains, so many investors become shorter-term focused and start trading, which may be outside of their competence. (2) It creates unique opportunities for medium- or longer-term investors who have done their work and are confident in their analysis. If the market weren't so whimsical, an investor might not be able find the blue chip company that he wanted to own at less than 10x earnings.
Nevertheless, volatility can cause investors to freeze and makes it hard to capitalize on these opportunities. Worse, it makes an investor go back and question his assumptions and himself, and it can shake him off a good position. The next day that the stock may be up 10-20%, it is very difficult to get back in, and can miss the big move up that the investor originally anticipated.
Imagine that you think that a stock is worth at least $15 and can get to $20 if the economy recovers sooner rather than later. So, you decide to buy at $10. However, a market correction and further momentum-trading causes the stock to drop to $5. You start questioning your assumptions and you decide to cut your losses short, so you sell out and live to fight another day. But the sell-off in your stock may have been caused by market outflows as mutual funds go more into cash or investors shift away from risk; this may have nothing to do with the underlying fundamentals of your stock's value. When the market recovers and re-focuses on the business fundamentals, investors start buying and the momentum works the other way. The stock may rise 10-20% within a few days, and at that point you say "I missed it" and decide to wait for another correction to buy it back at $5. Besides, you don't want to look like a fool, buying at $10, selling at $5, and buying back at $6 or $7. Then, you just sit there, frozen, as the market takes the stock price to $15 and then to $20.
The psychology behind investing is what makes a deep knowledge of fundamentals and conviction extremely important, particularly in a period of heightened volatility.
Disclosure: No positions