Financial Market Volatility

Financial Market Volatility: What Should Investors Do In a Market Downturn?

by Alexander Green, Chairman, Investment U; Investment Director, The Oxford Club
Monday, July 30, 2007: Issue #697

For months now I’ve been advising readers to pull in their horns a bit and take a more sensible approach to the financial market volatility.

Last week the Dow, the Nasdaq and the S&P 500 all fell roughly 5%. Other markets around the world tumbled as well.

You knew it had to happen.

True, the psychology has changed quickly. The Dow had tacked on 1,000 points over the last three months and crossed the 14,000 mark – a new all-time high – just the week before last. But markets never move in a straight line for long.

New investors, however, can be excused for thinking otherwise. After all, the bull market began back in October 2002, more than four and a half years ago. Since then stocks have raced steadily ahead, without the broad market suffering a 10% correction since March 2003. This is not the way the market generally acts.

Ordinarily, equity investors enjoy higher returns because they endure stomach-churning volatility from time to time. We were overdue for a pothole. And last week we hit one.

Let’s take a look at what has changed recently and what you should be doing with your portfolio now.

Housing Pains Spread to the Broad Financial Markets

At the root of last week’s market selloff was the weak housing market. Problems in residential real estate didn’t just suddenly appear, of course. They’ve been building like an approaching thunderstorm for months.

But last week the skies finally opened up.

Until then, most of the pain from the housing downturn had been confined to homebuilders, mortgage lenders, banks, and investors in subprime securities, which include a few major hedge funds.

However, the agony spread to the broad market when investors learned not only that the housing slump is deepening, but that there are rising payment problems among borrowers with good credit records too.

This stoked concerns of a potential credit crunch and a broader economic slowdown. If the economy weakens, it would depress corporate earnings and, ultimately, stock prices.

Some analysts were surprised that the market didn’t react better to Friday’s report that the U.S. economy grew at a strong 3.4% rate in the second quarter. But they shouldn’t have been. The market’s latest bout of nervousness is about what lies ahead, not just behind.

Second-quarter earnings may be unable to change the market psychology either. And that’s unfortunate, because most U.S. corporations are reporting pleasant surprises right now. According to Thomson Financial, more than half (290) of the companies in the S&P 500 have reported second-quarter results. So far 65% of them have beaten estimates.

Valuations are reasonable, too. Today the S&P 500 is selling for 16 times trailing earnings. That’s well below the average p/e of 21.7 for the past 10 years. And nowhere near the 2000 peak of 28 times trailing earnings. (In fact, the average p/e for the market the last 50 years is 16 times earnings – right where we are today.)

So how should you react to the current volatility in the market? That depends on whether you’re a trader or an investor…

Combat Market Volatility With These Two Approaches to Managing Your Money

An investor is long-term oriented and therefore ignores short-term fluctuations, except to see whether anyone in the market is offering to do anything foolish, like selling too cheap or buying too dear.

Long-term investors should stick to their guns. For example, The Oxford Club recommends long-term investors should have 30% of their liquid assets in U.S. stocks, 30% in international stocks, 10% in high-grad bonds, 10% in high-yield bonds, 10% in inflation-adjusted Treasuries, 5% in real estate investment trusts and 5% in gold shares.

A portfolio like this gives high real returns and experiences low volatility. Last week, for example, while both foreign and domestic stocks were getting a haircut, high-grade bonds and inflation-adjusted Treasuries moved higher.

Traders, on the other hand, are short-term oriented, not long-term oriented. They don’t ignore short-term fluctuations. They obsess over them. And last week’s fluctuations brought little good news, unless you were short the market.

My advice to traders is this: The market’s psychology has been bruised and will take time to heal. That means you should expect more volatility for now. Raise some cash. Avoid adding to your option positions (unless you’ve got a hair trigger). And keep a close eye on your trailing stops.

Most importantly, don’t heed the siren song of those seers who pretend to tell you what the market is going to do next. As Yogi Berra once remarked, “Predictions can be difficult, especially when they involve the future.”

No one can consistently call the market’s short-term gyrations. (Try it and you’re likely to get nothing more than an expensive education.)

So stick to our proven discipline. That means dividing your portfolio among non-correlated assets (stocks, bonds, gold, etc.), diversifying broadly, and running trailing stops behind your individual stock positions.

The market is likely to stay jumpy for a while. But you don’t have to be. The rewards generally accrue to investors who act unemotionally, regardless of how they’re feeling.

And remember, history shows that every market selloff eventually becomes an opportunity.

Stay tuned…

Alex

Today’s Investment U Crib Sheet

The housing sector led the downward charge last week

The Philadelphia Housing Index (^HGX) – composed of homebuilders, suppliers, mortgage insurers, etc. – is down 22% since May. Nearly half of that drop (9%) has come in the last five sessions.

Using the Select Sector SPDR ETFs, here’s how the rest of the market looked last week:

Of course, assets that aren’t correlated to stocks, as Alex mentioned, can cushion the fall and even make money. The chart below shows the S&P 500 in relation to Vanguard’s Inflation-Protected Securities Fund over that the past few weeks.

For the perfect blend of stocks, bonds, real estate and precious metals, here’s a closer look at The Oxford Club’s Asset Allocation Model.

To learn more about the Club, here’s how to get access to Alex’s current recommendations.

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