Be Smarter than the Average Bear
June 13th, 2006One of my daily routines involves looking at the market performances in Asia and Europe overnight. Often times this yields very little information from a purely macro standpoint. There are times, however, when what one sees as the day goes by in those places can portend some serious action in US markets. As a not so brilliant friend of mine once said during the 1998 Nagano Olympics, "so if the world ended right now, those bastards would have gotten one more day than we did?" Some days we might wish the world ended before the sun reached us…today could be one of those days.
This picture is a snapshot of the world markets as I write. I want to talk a little about the magnitude of these things and share a few comments that might help ease the pain as you watch the markets bleed red at the open.
This is a perfect day to look back at some of the points I have made in the last couple of months. You will notice that all of these markets are down over 2% with the Nikkei being beaten down over 4%. In the world of statistics and chaos theory this is what we call "meaningful". These events are greater than 2 standard deviations from the mean (2 SD's in the US S&P 500 is about 1.9%). In layman's terms that means these are very rare beatings. The fact that they are all coming at the same time across the globe is the worrisome part.
First the good news, as I mentioned in Volatility is Volatile and Eliminating Huge Portfolio Losses, events of this magnitude seem to cluster together. For you that means that there will most probably be more significant down days AND UP DAYS in the coming weeks. Notice I said up days as well. The largest UP days of all time tend to come within a very short time period from the largest down days. If the market takes a beating then it is likely overstretched by fear and will make a significant rebound. The problem is that the magnitude of that rebound, its timing, and its duration are unknowable.
The second point I would like to make sort of meshes with the quantitative info above. Days of extreme market fluctuation tend to be more swayed by crowd fear than by a true valuation of the assets. Someone in Japan smelled smoke and everyone in the theater started rushing for the exits screaming fire before they even see if there is a fire. People in the other surrounding theaters (Europe, India, etc.) hear the stampeding and leave their theaters even though they can't even smell the smoke. Herd mentality at its finest. The reason that large up days follow large down days is that eventually someone will walk back into the theater and notice that the fire was well contained and very small and that it is okay to continue watching the show. Then others follow and there is a reversal of the fear. The moral of the story - don't panic. It may be necessary to reshuffle your portfolio a little but the odds are that the world is not going to end immediately!
The last point I would like to make is that the reaction we are seeing here, global markets down across the board, is one reason why being well diversified doesn't always help. In massive down markets, global markets seem to be more positively correlated. If the U.S. hikes interest rates (which seems to be the catalyst for this giant move) and the rest of the world views this as supremely negative then they will indeed stampede to the exits simultaneously. Fear begets fear. More often than not, world economic slowdowns affect all countries in some form or another and their markets will be more positively correlated than when they are all rising. In a world bull market we can look to any number of differing catalysts for each country as its reason for rising. In those times markets seem to be less correlated because whoever is telling the best story is where all the money goes. The moral of this story? Just because you have that perfect balance of US and International stocks does not mean that one is going to zig when the other zags. They might very well zag together during times of extreme negative sentiment like we are seeing develop today. I'll speak more about this in the future.
Funny, I awoke this morning with the intention of writing a nice little piece about dividends and the slow methodical way of making a good retirement from them. So I buy my ticket and on the way in I get hit with the stampeding herd. I thought it best to reflect on that a little before moving on. I hope you find the thoughts above useful.
Follow Up:
I suppose the herd decided to go back into the theater a mere two days later...these are all sizable moves to the upside...at about the 1.5 standard deviation level.
"It is change, continuing change, inevitable change, that is the dominant factor in society today. No sensible decision can be made any longer without taking into account not only the world as it is, but the world as it will be."
-Isaac Asimov
Disclaimer: this post is for informational purposes ONLY. Please read the disclaimer before even thinking about relying on me to make a financial decision!
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Volatility is Volatile
Eliminating Huge Portfolio Losses
Waxing Philosophical on Markets, Chaos Theory, and Crowd Psychology
2006 = 1987? Impending Doom or False Connection?
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