Beware the Alarmist

Investing is counterintuitive. You try to buy when prices are low, which makes good intuitive sense. But then you're supposed to hold while others are selling, which doesn't feel very good. You're also supposed to ignore, or at least not fall prey to, hyperbolic news headlines when prices are down. This can be hard too, especially when headlines start getting interesting. And yesterday, when the Dow was briefly down 1,600 points and the media nearly went berserk, it's just plain hard.

Making this even more challenging, the closer you pay attention the more you see the odd way markets react to news and economic data. So odd, in fact, that markets can react differently to the same type of news depending on the general outlook and sentiment of the day. Good can be bad, up can mean down, and, if you're not careful, confusion can reign supreme.

Take the current market decline as an example. Economic reports came out last week showing how our economy is continuing to expand and the growth trend is largely positive. Intuitively, you think great, economic growth is a good thing, is better than the alternative, so stocks should keep moving up, right? Well, this is where the counter intuitive nature, and even manic tendencies, of the stock market comes into play.

The market likes growth so long as is doesn't come with inflation and short-term interest rate increases by the Fed. Since all three ultimately go together, what the market really doesn't like is not knowing how much of each will be present and when. The market had become complacent about this and is now waking up and repricing itself accordingly. The bond market did so quickly because it had less distance to travel. During yesterday's decline sellers of stocks finally started buying bonds, which helped bond prices turn positive. Stocks, on the other hand, had run up so much lately they had farther to fall.

The Dow experienced its largest one-day point decline yesterday, finishing down 1,175 points. The S&P 500 also had a bad day. Remember, however, that both indexes are tallied in points, but the percentage moves are what's important. All told, yesterday the Dow was down 4.6% and the S&P was down 4.1%. Bonds were up 0.4%. What else was up? The VIX, a gauge of volatility and investor "fear", was up over 100% on the day.

Lots of volatility, over a year's worth, crammed into about a week. Ouch. If your head is spinning a bit, then you're not alone. Fast and furious seems to be the way of the markets these days, both on the upside and the downside. While the speed of markets can be disconcerting, it's nothing to worry too much about as ultimately this speed provides more liquidity and pricing transparency.

As markets reprice themselves there will be more volatility. Historically, the stock market stays volatile for at least a couple of weeks after a sharp decline. So, try not to panic and remind yourself that investing is a long-term business, market declines are normal, and can and do happen within a continued bull market.

Along these lines, the following short article from Bob Veres, a planning and investment industry guru, sets the right tone. It's a reminder that one of the worst things we can be while investing is an alarmist. The article was written last weekend referencing last Friday, before yesterday's decline, but is only more important now.

Suppose somebody came up to you and shouted: "I have terrible news about the economy. I think you should sell your stocks!"

Alarmed, you say: "Oh, my God. Tell me more!"

And this mysterious stranger shouts: "Run for the hills! The American economy just added 200,000 more jobs—more than expectations—and the U.S. jobless rate now stands at 4.1%, the lowest since 2000!"

You blink your eyes. So?

"There's more," you're told. "The average hourly earnings of American workers have risen a more-than-expected 2.9% over a year earlier, the most since June of 2009! You should sell your stocks while you can!"

Chances are, you don't find this alarmist stranger's argument very persuasive, but then again, you don't work on Wall Street. After hearing these benign government statistics, traders rushed for the exits from the opening bell to the closing, and today the S&P 500 stocks are, in aggregate, worth 2.13% less than they were yesterday. The Nasdaq Composite index fell 1.96% and the Dow Jones Industrial Average, a somewhat meaningless but well-known index, was down 2.54%.

To understand why, you need to follow some tortuous logic. According to the alarmist view, those extra 200,000 jobs might have pushed America one step closer to "maximum employment"—the very hard-to-define point where companies have trouble filling job openings, and therefore have to start offering higher wages. No, that's not a terrible thing for most of us, but the idea is that if companies have to start paying more, then they'll be able to put less in their pockets—and the rise in the hourly earnings of American workers totally confirmed the theory.

If you're an alarmist, it gets worse. If American workers are getting paid more, then companies will start charging more for whatever they produce or do, which might raise the inflation rate. "Might" is the operative word here. There hasn't been any sign of higher inflation, which is still not as high as the Federal Reserve Board wants it to be. But if you're a Wall Street trader who thinks the market is in a bubble phase, you aren't necessarily looking at facts to confirm your beliefs.

Suppose you're not an alarmist. Then you might notice that 18 states began the new year with higher minimum wages, which might have nudged up that hourly earnings figure that looked so alarming a second ago. And some companies have recently announced bonuses following the huge reduction in U.S. corporate tax rates, whose amortized amounts are also finding their way into wage statistics.
Meanwhile, those same government statistics are showing a resurgence in factory activity and a rebound in housing, which account together for more than 50,000 of those new jobs.

So, the question we all have to ask ourselves is: are we alarmists? Selling in anticipation of a bear market has never been a great strategy, even though stocks are admittedly still priced higher than they have been historically.

If you are not an alarmist, then you have something to celebrate. The S&P 500 has now officially ended its longest streak without a 3% drop in its history. It's an historic run not likely to be seen by any of us again. The truth about the markets is that short, sharp pullbacks are inevitable and routine—unless you were living in the past year and a half, when we seemed to be immune from normal market behavior.

Have questions? Ask me. I can help.