Sunday, August 19, 2007

A Stock Market Scenario - Going From Bad to Worse

"Things are going to get a lot worse before they get worse." Lily Tomlin

On Friday, the indices hit the prerequisite 10% decline to qualify as a correction. 30% volatility is the highest level since March, 2003. Real estate prices are declining or, at best, stagnant. Housing starts are at a 10 year low. Mortgage brokers are going bankrupt. People with excellent credit ratings can't get mortgages. Ben Bernanke isn't planning to cut the Fed Funds Rate, because there isn't a threat to the economy...yet.

Last week I thought the Fed breathed new life into the bull market. I've changed my mind. Here's why it's going to get worse:

It's a transition to a new economy. Globalization, interdependency, new people, and volatility have voided the old models. People still remember when Alan Greenspan and the Fed were able to single-handedly change the course of the economy and stock markets. Mr. Greenspan is gone, and more US debt is owned by foreign countries than ever before.

There are more factors, new factors to consider, which were part of the previous equation. While Dr. Bernanke is a smart guy, it's pretty tough to be exactly right for a situation one has never encountered before.

It's about unknown probabilities. Investors and traders are getting whipsawed. Will the Fed cut rates? Will liquidity be restored? Is this the bottom? Is the the beginning of a protracted bear market? Should I short the market? Nobody knows. Worse yet, the models aren't working because they depend on some level of predictability. Right now the Fed is not acting the same as when Alan Greenspan was chair. Ben Benanke is still an unknown quantity for these types of situations.

So it's about considering possible scenarios and preparing for them. What if the Fed doesn't lower interest rates? What would be investment strategies for this situation. What if the Fed does and interim reduction? What if the Fed reduces interest rates in the September meeting? What are strategies for these situations? What is the probability of each situation?

As a result, quantitative analysis, in the short term, is not working. Factor values are changing too quickly, no one can predict what the Fed will do, and everybody is very anxious. To note, some hedge fund quants are being decimated. More will come. This is a the type environment for irrational actions to take place. This is an excellent time for people with experience and good intuition to take advantage of individual stocks being mispriced.

Net, we should all be getting ready for a wild ride. At this time, I've decided to buckle up and hold tight. While the Fed is willing to let excesses be purged from the market, they don't want to go into recession. While the short term will be very volatile, the economy is still strong and I expect the market will recover. I believe large cap, financially secure stocks will survive and thrive after this current shakeout of the market excess. I'm staying in the market, but making no new purchases.....for now.

For more on New Beginnings, check back every Sunday for a new segment.

This is not financial or investing advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

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