Blog Post

                Where do we go from here?  That has always been the most important question that any investor can ask.  As a person who reads volumes of research each day, I see that most commentators focus on what events have occurred in the past and how those events can be used to determine where we head in the future.  After all if we know where stock prices will be tomorrow, it becomes very easy to earn money today.  Unfortunately foreseeing the future is neither easy nor precise.

                Most investors receive information from a few different sources.  Whether it is television, newsletters or some other medium, knowledgeable investors seek information that will allow them to prosper.  With many different ideas swirling in the air, you can always find someone who has an idea that resonates with your thought process.  Think housing has bottomed?   A professional investor can supply reams of data to justify your view.  Think the economy is headed for a depression?  A different investor can share information to support your thesis.  As ideas conflict, people enter into investment transactions that reflect these various views.  In theory, the mass conflict of ideas arrives at a point where stock prices are efficient and reflect all known information.

                So what happened last week?  To review, the Dow Jones Industrial Average (DJIA) dropped 429 points (3.4%) on the week.  Within that drop we saw a 101 point decline, a 214 point rally and a 395 point decline.  During this process, positive information on retail sales and the Federal Reserve's (Fed) decision to defend the dollar offered reasons to drift higher while an increase in the unemployment rate and an $8 spike in oil justified the decline.  While the explanation for the price swings is simple, it is more difficult to determine if enough had changed in the underlying economy and business fundamentals to justify such swings.

                As one who never put much faith in the idea of efficient markets, I will leave it to others to determine if last week's increased volatility is justified.  For me, I am more interested in determining what we have learned from the events and how to profit in the future.  With lower stock prices, a few things are clear.  The first is that investors are feeling less optimistic than a week ago.  The second thing we know is that the cost of buying ownership positions is lower now than it was a week ago.  Both of these facts are key in creating a long term strategy to create wealth.

                Whether or not you believe in market efficiency, the presence of millions of profit seeking investors makes following consensus views a difficult approach to achieve success.  The best opportunities arise when you can develop an idea that is contrary to the majority yet is also correct.  The need to take a contrarian view is essential to profit.  This is where a lower market helps.  As investors were throwing stocks out the door, an opportunity arose for a contrarian to step into the void and buy companies others did not want. 

                To buy when others are selling sounds simple, but there are a few nuances that most be noticed.  At times, investors are justified for selling.  An example would be if the markets have experienced an increase in value that is not justified by the fundamentals, you do not want to buy on dips.  In this case, the drop is justified and buying it will results in losses.  A generation of investors during the 1990s was taught to buy every dip and sell every rally.  As a bull market moved higher, this strategy produced predictable profits.  However, as the bull turned into a bear buying dips led to large losses and investor frustration.

                Therefore, you do not buy when others sell, but buy when the selling is not justified by the market environment.  So was Friday's selling justified and should we be buying at these levels?  For me, this answer is less clear.  As I have written over the prior weeks, the rally off the April lows were based on the hope that the Fed would save the economy, housing would soon bottom and that escalating commodity prices would either stop rising or not harm the economy.  Never believing any of these arguments, the recent drop in the DJIA looks more like justified selling than a contrarian buying opportunity.  Also, not all dips are the same.  As the DJIA peaked above 13,000 in mid-May we saw many drops followed by rallies.  During this time, price drops were occurring as stocks were consolidating gains.  In that environment, buying dips led to profits.  Recent market information indicates that the current declines have accompanied stocks that are breaking down.  Buying these dips will often lead to losses.

                Before we reject this selloff as an opportunity to buy stocks, we must also examine the values the market presents us.  As mentioned above, stocks are clearly cheaper now than they were a week ago.  If we want to buy long term positions in strong companies, is now the time to do so?  Again, this answer is unclear.  Looking at my research universe, nearly 15% of all stocks I follow are selling at prices where investors are being compensated for the risks they take.  This is the highest number of cheap stocks I have seen in almost 5 years.  Unfortunately, most of these companies have exposure to the credit crisis.  One thing we have learned during the credit crisis is most banks do not have an accurate view of what they hold on their balance sheet or the true value of those assets.  Therefore, we must ask ourselves at what point financial stocks evolve from investments to speculation.

                So as I asked at the beginning of this article, where do we go from here?  Despite last week's large drop I am not convinced we have reached bottom.  Over the past two days, the market foundation has started eroding as price declines are met with higher volume, more stocks breaking to new lows and negative breadth.  A market that had shown signs of consolidating gains is now showing signs of breaking down.  Without compelling values to justify increasing my equity exposure, I would rather rent stocks than own them.  Eventually, this market will offer an excellent opportunity to buy strong companies at low prices.  We are not there yet.