Our Thoughts

Roller Coaster Ride

U.S. stocks fell last week after Federal Reserve chief Ben Bernanke said the Fed may phase out monetary stimulus.  The S&P 500 slipped 2.1 percent to 1592.43 over the five days, trimming its 2013 gain to 12 percent.  What’s going on?

There are two kinds of investor in this world.  One type pays close attention to the daily (and sometimes hourly) flood of information, looking for a reason (any reason) to jump in or out of the markets.  The other kind of investor is in for the long haul, and recognizes that the markets are going to experience dips and turns.  If these people are particularly wise, they know that the dips and turns are the best friend of the steady, long-term investor, because as you put money into the markets, as you rebalance your portfolio, you gain a little extra return from the occasional opportunities to buy at bargain prices.

Last week, the investment markets made an unusually sharp turn on the roller coaster, and showed us once again the sometimes comical fallacy of quick trading.  See if you can follow the logic of the events that led to last week’s sell off.  Federal Reserve Board Chairman Ben Bernanke and the Federal Open Market Committee issued a statement saying that the U.S. economy is improving faster than the Fed’s economists expected.  Therefore (the statement went on to say), if there is continued improvement, the Fed will scale back its QE 3 program of buying Treasury and mortgage-backed securities on the open market, and ease back on stimulating the economy and keeping interest rates low. 

Everybody knows that the Fed will eventually have to phase out its QE 3 market interventions, and that this would be based on the strength of the economy, so this announcement should not have stunned the investing public.  Nothing in the statement suggested that the Fed has any immediate plans to stop buying altogether; only to ease back as buying becomes less necessary.  The statement said that this hypothetical easing might possibly take place as early as this Fall, and only if the unemployment rate falls faster than expected.

The result?  On Wednesday and Thursday there was panic in the streets, or at least on Wall Street, with the S&P 500 posting its biggest two-day decline since November 2011.

In addition – and here’s where it gets a little weird – stocks also fell sharply in Shanghai and across Europe, and oil futures fell dramatically.  How, exactly, are these investments impacted by QE 3?

One explanation for last week’s panic sell off is that thousands of investors must have listened to “we plan to ease back on QE 3 when we believe the economy is back on its feet again,” and heard: “the Fed is about to end its QE 3 stimulus!” 

It is possible that the investors who sold everything they owned on Wednesday and Thursday will pile back in this week, but it is just as likely that the panic will feed on itself for a while until sanity is restored.  If stocks were valued daily based on pure logic, on the real underlying value of the enterprises they represent, then the trajectory of the markets would be a long smooth upward slope for decades, as businesses, in aggregate, expanded, moved into new markets, and slowly, over time, boosted sales and profits.  The roller coaster ride that we actually experience is created by the emotions of the market participants, who value their stocks at one price on Tuesday, and very different prices on Wednesday and Thursday.

The long-term investor has to ask: did any individual company in my investment portfolio suddenly become less valuable in two days?  Did ALL of their enterprise values in the aggregate become less valuable in 48 hours?  And, at the same time, did Chinese and European stocks and oil also suddenly become less valuable?  Phrased this way, the only possible answer is: no.  And if that’s your answer, then you have to assume that eventually, people will be willing to pay the real underlying value of the stocks in the market, and the last couple of days will be just one more exciting example of meaningless white noise.