Saturday, August 14, 2010

Why The Market Will Keep Falling

Economic indicators have been on the decline for several weeks now. However, it took until this week for investors to flee from equities. To understand why the market took so long to respond to the souring data you have to understand that a Catalyst is usually required for stocks to begin moving in unison with reality. You also have to understand that a Catalyst is the fourth, but most important, of four keys key to successfully timing a move in the market (or individual stocks for that matter):

1. Understand the environment -- Observing what's happening in your neighborhood can help, but it isn't enough. You need a broad view of what's going on with business and economics, in the U.S. and worldwide. Several objective sources can be found on the Internet.

2. Understand when the government and/or Fed will intervene and if the intervention will help -- When the economy is in danger, the government and/or Fed will inevitably intervene to save the day. If you short the market and an intervention occurs the next day, you’re probably going to lose money.

In this case, my feeling has been that the government wouldn’t do much, because “stimulus” has become a dirty word with the public. With elections looming, nobody in Washington can afford to risk angering the electorate. Thus far, that has proven half-right. Unemployment benefits were on death’s door, but were eventually reinstated. That was a good way of pumping money into the economy without making too many people angry. In addition to this, the Fed has been making some minor moves of its own. This is also a savvy political move, because the public doesn’t generally associate the Fed with a political party.

The bottom line is that intervention remains possible. Keep in mind, almost any intervention will hurt the value of the dollar, but the government and Fed seem perfectly willing to sacrifice the dollar to keep GDP from falling (the definition of “recession”). Also keep in mind that a falling dollar almost always generates higher stock prices.

3. Understand if the market reflects reality -- Most of the time, this is pretty easy. If reality looks bleak and the market hasn’t dropped, something has to give. Either stimulus is on the way or the market is due to roll over. In this case, the government and Fed have both made some moves (as I discussed above), but I don’t think it’s enough. Based on the market’s reaction over the past couple of days, investors seem to agree with my view.

4. Understand the Catalyst -- The market doesn’t always respond to reality in real-time. In fact, experience has shown that it almost never does. Back in November of 1999, there were clear signs that the Internet bubble was bursting. Despite this, the market didn’t peak until March of 2000. If you shorted the market in November of 1999, you could have gone bankrupt -- a harsh reward for being right about what was coming. Similarly, in May of 2007, it was clear to me that the real estate bubble was coming to an end. However, the market churned higher until October, some 5-months later.

Knowing what’s going to happen next is great, but knowing what will make investors act on that reality is what will make you rich.

Most recently, I published a SeekingAlpha article entitled “Which Way Is the Market Going Next?”. In that article, I wrote that the economy was starting to turn south again. I also stated my opinion that the market would start reflecting this reality “very soon”. Over the next week or so, the NASDAQ slid from 2,242 to 2,160...but almost as quickly rebounded, shooting above 2,300. Only in the past couple of days has the market fallen back below 2,242.

Assuming we are now in the midst of a correction, my call took a month to be proven correct. The reason my timing so far off was a misinterpretation of the Catalyst -- the event(s) that would make investors believe (and more importantly, act on) my interpretation of reality. In this case, I felt that investors would simply see the writing on the wall and start selling stocks, despite what I felt was going to be a relatively healthy Q2 earnings season.

That was my mistake. As good earnings rolled in, investors ignored signs of a bleaker future in favor of reports of a brighter past. Then, as earnings season wound down, investors refocused on the economy, but believed that the Fed would come to the rescue at this week’s FOMC meeting.

It was a valid argument, but as it turns out, the Fed's stated plan-of-action proved disappointing. Worse yet, with elections coming in November, the Fed is likely to honor its tradition of maintaining its status quo in the months leading to an election (for fear of being seen as politically biased).

With no more positive Catalysts upon which to cling, investors are left with no choice but to face reality. Thus, the Catalyst for a market decline was born.

In the coming weeks, I believe we’ll see more signs of economic degradation. With earnings season winding down and the Fed meeting behind us, positive Catalysts appear to be exhausted for now. Barring a surprise government or Fed intervention (unless, barring a full fledged crisis), the near-term Catalysts are likely to be negative, lighting the way to further stock market declines.

Article from Seeking Alpha

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