Saturday, March 03, 2007

The Market "Meltdown"

The stock market really got hit this week, losing essentially all its gains since Thanksgiving in a single day (Tuesday, February 27). In a way it seemed to come out of nowhere from a steady advance that started last summer, but actually we were long overdue for a decline of several percent.

All it needed was a trigger, and the trigger seemed to be some comments by former Federal Reserve chairman Alan Greenspan to the effect that the U.S. might enter a recession in 9 to 12 months. Hong Kong and China stocks plummeted, and the same effect traveled around the world throughout the trading day. This was promptly contradicted by the current chairman, Ben Bernanke, who said we were not headed for a recession, but the damage had already been done.

Who's right? The experts who seem most credible to me say no, we won't have a recession, but yes, we will have to go through a market correction -- not a crash. Companies are making good profits, and that after all is where rising stock prices ultimately come from.

This is scary, but if you are following good investing principles (including diversification, and that includes some bonds, which are going up) you should be OK. There is talk of a possible worldwide panic caused by forced selling of assets bought with borrowed money (especially borrowed Japanese Yen, due to their extremely low interest rates), but there's always some "doomsday scenario" to worry about and it's just the latest.

So is it time to buy, or to sell? Well, it's very unlikely that we're at the bottom. Estimates for this correction range from 2 weeks to 6 months, and from 5% to 17% down from the recent peak. Nobody really knows of course, but there definitely is damage in the market that will take some time to repair.

But dumping your investments first thing Monday morning is probably not the best thing to do either. First, if you sell, you have to know when to buy it back. Almost nobody can get this right! It's psychologically almost impossible to pull off. Second, we will probably have a bounce in the next few days, which will present a better selling opportunity. Third, there are tax implications in selling.

But you could trim some of your investments, particularly the ones that aren't acting well, and buy better ones later. (What kind? Everything I hear says buy large blue-chip growth stocks.) Selling little by little, and buying back little by little, is psychologically easier.

Instead of selling things, you could hedge by buying some of the inverse mutual funds or ETFs (exchange-traded funds) such as the ones sponsored by Rydex and ProShares. The inverse funds go up when the market goes down.

But again, don't go all out. Whenever you make a big buy or sell, that's when the market will reverse on you. Humans are psychologically programmed to do precisely the wrong thing; that's why profitable short-term trading is so extremely hard.

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