In the aftermath of this massive stock market decline, there were pundits galore that expressed their opinions on why the market saw such a move down. Some blamed it on a system failure (ala CNBC's Jim Cramer) others bemoaned the Chinese stock market that supposedly triggered this decline, and another still blamed this sell-off on Alan Greenspan's use of the "r" word...recession. Perhaps the most mind-boggling blame was placed on Matt Drudge of the Drudge Report. I guess Drudge was responsible for simply reporting the news.
As always, I want to give you my spin on things. First, I do want to point out that in my opinion this decline was not an aberration or simply a technical glitch in the system. It is the beginning of a major correction in the U.S. stock market. The panic that occurred on Wall Street tells me that most investors are not as optimistic as they come across. If they truly believed that the US economy was robust and that the stock market was headed for a strong year, there would be buying. Instead, there was selling. And lots of it.
Now I want to make one thing abundantly clear. I do not think that we will see a precipitous sell-off in the markets where we see a 20% decline in a single day. The bounce back in the market was to be expected. However, I do think the sell-off will be more staggered where it will eventually reach a 20% + decline. There will be rallies where investors will jump in thinking that this correction is over. I would caution against this. The fundamentals, market environment, and investor sentiment warrant a much larger correction in the near future.
I also wanted to touch upon several more interesting aspects of this recent sell-off and thoughts that came to my mind as I saw the stock market decline unfold. I will break these thoughts into several points.
1) "The Blame Game Mentality" - What we saw in the last couple of days is "the blame game" mentality that has become en vogue on Wall Street. Gone are the days where market declines were blamed on fundamentals or simply characteristics of how markets move. To be fair, there have been some that have correctly argued that the U.S. market was due for a correction and that the current economic environment does not bode well for the economy. By in large, however, many have blamed factors that are simply ancillary to the larger problems that face this economy. Indeed, instead of viewing this sell-off as a "wake-up" call, they simply viewed this as another opportunity to play the blame game.
2) "Denial" - Tied into this "blame game mentality" is the simple fact that most are in denial of what is currently transpiring around them. Consider, for instance, the dismal economic news that has occurred over the last couple of weeks. Inflation numbers jumped at a higher than expected rate, orders placed with US factories for durable goods fell by more than expected, and the January's ISM numbers signaled a contraction in manufacturing. To top it all off, housing is far from bottoming and sub-prime mortgages are in a dizzying spiral. Take a look at two of the many statistics surrounding the housing market. New home sales had the biggest drop from a previous month (16.6%) in 13 years. There are over a TRILLION dollars of sub-prime mortgages. Since sub-prime mortgages are given to individuals who have below average credit, I would imagine that there will be a substantial default rate. The default will not only affect the borrower, the lender, but also the butcher, the baker, and the candlestick maker that have benefited from this real estate rise. In other words, mortgage defaults and a real estate slowdown will play havoc on a variety of businesses.
Interestingly enough, most investors are in denial of the current financial makeup. While corporate profits and cash flows have undoubtedly been strong over the previous several years, using this reason to rationalize what will likely happen in the future is getting old. Corporate profits will dry up as quickly as the consumer says, "I can't afford to make my mortgage payments" or "I have to cut back on my spending because my adjustable rate mortgage just went fixed".
3) "What we have here is a failure to focus on the fundamentals." - Most of what is transpiring falls back to what I have been saying the last couple of years. Last January, I wrote a commentary titled "Real Estate Burst, Upcoming Recession, and Soaring Commodity Prices" Now, I am not bringing this up because I want to say, "I told you so." I am the first to admit that the real estate market has lasted longer than I anticipated and the stock market has appreciated much further that I would have imagined. However, as many people know... The market can stay irrational longer than you can stay solvent. What I do want to bring up is that it is key and important to focus on the fundamentals. You cannot just sweep all of the bad economic factors (whether it is housing, inflation, or the fact that the consumer has over-extended himself) under the rug. Focus on the fundamentals...it is what ultimately moves the markets.
4) Understanding The Fundamentals Will Also Provide You With Buying Opportunities. - One of the more interesting moves that occurred in the last couple of days happened in the gold market. In the previous week, gold rallied to new highs as geopolitical tensions, higher than anticipated inflation numbers, a declining dollar, and rising energy prices brought in buyers for a number of different reasons. Around the $690 level, gold looked strong for a quick break to test the $720 highs. Instead, gold prices decelerated quickly in after hours and plummeted by more than $25/ounce to hover around the $660 level.
Interestingly enough, the sell-off in gold could not be attributed to any of the above mentioned factors. The U.S dollar did not have a strong rally on the upside, oil prices did not plummet, the inflation numbers from last week were not revised downwards, and there was no resolution in the Middle East. Instead, the market ignored positive signals for gold (declining dollar, the attempted attack on Vice President Cheney [increased geopolitical tensions], stable oil prices, and market instability which typically results in buying of a historical safe haven). It seems to me that investors panicked by selling everything in sight, funds liquidated profits in gold, and the downward decline in gold was not fundamentally warranted. If anything, it provides a buying opportunity. I firmly believe that gold is heading higher within the next 60 days and we will be re-testing the $720 highs.
5) Understand The True Meaning Of Diversification. - Another lesson to learn from the market sell-off is that investors who think they are diversified because they have stocks across various sectors and various international markets should realize that their diversification is limited. Domestic and International Markets, large and small cap stocks, and a variety of sectors all experience declines in this stock market sell-off.
The idea behind diversification is that you want to construct a portfolio that has investments that either have a low or negative correlation to each other. Consider allocating an alternate asset class in your portfolio that is not correlated to stocks and bonds. One of these asset classes is managed futures. I was on CNBC on Tuesday talking about the benefits of managed futures as a non-correlated and diversifying asset class. If you are interested in viewing the interview and receiving a free complimentary brochure on Managed Futures you can request one here:
In short, here are several benefits of managed futures:
- The Opportunity for Reduced Portfolio Risk
- Potential For Enhanced Portfolio Returns
- Ability To Profit In Any Economic Environment
- Ease of Global Diversification
You can also see the benefits in the following chart which shows the performance of managed futures during several periods of worst declines for various stock sectors.
Source: CBOT
Futures and options trading involves substantial risk and is not suitable for everyone.
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