August 2011 Volatility in Markets

An overview of my thoughts from the past two weeks:

• Emotions do not play a role in our investment strategy
• Emotion has a fleeting—but also very unpredictable—influence on stock prices.
• We try to be blunt and clinical in our approach to investing
• We believe that setting an appropriate asset allocation and sticking with it is the only way to invest (unless you’re a trader, in which case you can expect to lose)
• We believe investment decisions are best made with a cool head
• History shows that investors who follow the herd and jump in and out of investments fueled by event-driven emotion generally make matters worse for themselves
• We believe that each investor should be guided by his or her personal risk tolerance and individual character traits
• We encourage clients with long-term investment goals to remain focused on the long haul

More specifically:

• Many investors have moved into panic mode
• There is no single piece of news driving the sell-off—instead the market seems to be gathering downward momentum on its own
• Selling is creating more selling
• Like 1987, the sell-off does not yet appear to be driven by fundamental factors.
• Some market-watchers argue that the fundamentals suggest that stocks (particularly blue chips) are undervalued and getting more so as prices drop.
• Some investors assume (or wonder) if the sell-off is indicating deep economic problems (however, as of yet, there is no evidence that this is true).

Note: Today, August 8, after weeks of the naysayers’ (including untrustworthy politicians) dire warnings that a credit downgrade would result in rising interest rates, interest rates (including the downgraded Treasuries) promptly declined.

The facts:

• The Federal Reserve is running an accommodative monetary policy
• The Fed is holding the funds rate near zero
• Corporate earnings are rising rapidly
• S&P 500 earnings are up 20% over last year and the S&P 500 P/E ratio (on forward earnings) is roughly 12—many pundits say this makes the market cheap

In the end, many commentators believe that the sell-off looks more like a technical correction in the market rather than a fundamental change in direction (corrections are defined as a decline of 10% to 20% from the market highs). This does not mean that it will end soon. Corrections run their course and then end.

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