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On the market and other Friday notes. October 10, 2008

Posted by shaferfinancial in Uncategorized.
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From Investopedia---Capitulation: In the stock market, capitulation is associated with "giving up" any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling.

For those who are wondering it is now apparent that capitulation is what is going on at Wall Street this week.  When will it stop?  Don’t know!  But we do know that this is not a once in a lifetime occurrence.   Since WWII there have been 10 bear markets (greater than a 20% decline) in the S & P 500.  That averages out to one every 6 years or so.  The average decline was 31.5% in these bear markets.  Two (1973-74 & 2000-2002) were around 50%.  Currently we are at around a 41% decline.  This feels like it might be one of those 50% declines.  The point is that this is not unusual in any way unless it goes to -60%. 

The second point that this drop does not have a corresponding fundamental reason.  Bear markets are just as irrational as bull markets.  All those mathematicians who try to tell us the markets are perfectly rational are simply wrong, the markets have always been more emotional than based on fundamentals in the short run.  The long run they are correlated with profits, but bounce around irrationally on a day to day basis.

Here is a chart of the S & P 500 Index going back to 1950.  Looks pretty scary at the end, but that is a function of the scale.  In other words because of the growth the absolute numbers are much larger making it appear to be larger percentage drops at the end.  Changing it to a log base 2 scale (don’t worry about the math) allows our minds to make better sense of the proportion.

Now we see, that there are no unusual variations from this weeks drops!

However, the media does what it always does and makes it seem like the end of the world.

Here is a couple of sentence from my forthcoming book.

The truth is that several times a decade mutual funds drop over 20%. It was only 20
years between times that the S&P 500 dropped 50%. So we see big drops aren’t unusual for stock funds. Wall Street has sold mutual funds as a way to not have risk or at least avoid most of it. Now the truth is you must assume some risk in order to build wealth. Instead of that message, the message is that mutual funds diversification makes risk disappear. So is it surprising when individuals who are sold on an investment that has little risk, react badly when their funds lose value?

Yesterday, I pointed out that mutual fund outflows forces selling. Add in investor panic and you have the recipe for what has been happening! My best advice, build a plan that suits your personality and does not require unrealistic returns to find success.

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