standard definitions

Commentators often use sound-bite definitions for economic and stock market phenomena.  For example,

–a recession is two successive quarters of year-on-year GDP decline.

–a correction is a short, counter-trend, fall in stocks of 5%-10%.

–a bear market is a fall in stock prices of 20% or more.

The virtues of these definitions are that they’re brief and unambiguous.  On the other side of the coin, brief and unambiguous doesn’t represent real life that well.

adding complexity, but also relevance

There’s a time aspect to corrections and bear markets.

A correction typically lasts a few weeks.  That’s because it’s normally a valuation issue–that “animal spirits” have pushed stock prices higher than near-term earnings can comfortably support.  Short-term traders sell, but intend to repurchase in short order, hopefully at somewhat lower prices.

Bear markets, on the other hand, come in two types.  Both anticipate–and ultimately reflect–widespread economic weakness that will last for a year or so.  The garden variety is a consequence of governments’ countercyclical fiscal and money actions when economies are about to overheat (too bad Mr. Greenspan forgot about this part of his job).

The really deep ones come from one-time shocks to the system.  In the past, these have been “external shocks,” like huge oil price rises.  The most recent is the self-inflicted wound of the financial meltdown.  As we experienced in 2007-2009, these ones are deeper and longer.

for the record…

…I don’t think we’re in a bear market–at least not in the world outside the EU (where stocks have already lost over a third of their value since May).

I think we’re in an unusual situation of correction in world markets, complicated by the EU situation.  In brief, the EU hoped to get away with not rebuilding its banks’ strength after the losses they took in the financial crisis, but hiding them instead.  They figured they could free-ride on the economic coattails of China and the US instead and use worldwide growth to mend.

Then the Greek crisis came.  And, instead of addressing the fact their gamble had failed, EU governments have spent the last year with their heads in the sand, letting the problem get worse.

why bring this up now?

EU stocks have lost over a third of their value since May.  US stocks are down by almost 20% (the “magic” bear market line).  Metals prices are crashing.  Stocks have been extremely volatile.

Monday morning I saw a lot of crazy stuff when I turned my computer Monday morning.

–European markets were down 5% intraday.

–Hong Kong-traded Ping An Insurance (I own it–ouch!) had lost another 8%+.  It was down by 25% in three days on rumors that HSBC was about to sell a portion of its holding (so what, I say).

–AAPL lost $10 in early trading in a rising US market on a report out of Taiwan that orders for iPad components from Hon Hai for the December quarter were lower than expected.  It turns out the orders, if they are indeed being lost at Hon Hai, are most likely going to a new iPad factory that’s opening in Brazil in December. It could equally be that AAPL is preparing for iPad3, which would be a bullish sign, I think.  But, noooo. Traders took the most bearish interpretation.

The world isn’t 5% better one week, 6% worse the next, and 7% better the week after that.  Economic processes don’t change that fast.  Human emotions do, however.  And the extremes of emotion we’re seeing now typically signal significant turning points in market behavior.  Hence the title of this post.

what to do

My best guess is that we continue to move sideways in markets ex the EU until European governments address their banking crisis.  They markets probably rally.  But that may not be for a while, so don’t bank on that.

I think the best strategy is to use days of crazy selling as a chance to buy stocks that are being irrationally sold down.  Be very picky, though.  Look for high quality names where you’re very confident about the fundamentals.  And don’t bet the farm on a single stock.

On September 6-9, for example, I bought INTC, because I saw it was trading at under $20 a share, or less than 9x earnings, and with a dividend yield of 4.3%.  As/when it reaches $24, I have to decide whether I keep it.

if it’s a bear market, then what?

Then markets are not turning up again until maybe next summer.  And, if past form holds true, we’ll see at least one more downdraft in stock prices–maybe another 10% from here, more in economically sensitive stocks and in emerging markets securities (even though the emerging economies themselves may be fine).  That will come as government statistics and company reports show economic activity dipping into negative territory.  Yes, world stock markets may have begun discounting this possibility.  But, ex the EU, they’re barely begun to, in my view.

As much as it cuts against the grain of my growth stock temperament, it seems to me it’s worthwhile thinking about asset allocation and how you’d act if a more ursine mood begins to make itself evident on Wall Street.  My portfolio is betting against this, but it never hurts to think about what happens if you’re wrong.