A Passing Storm

Although I spent most of my youth trying to avoid schoolwork, mythology always captured my interest. I was especially fascinated by the ancient Greeks' personification of history, value systems, and culture through shared tales of supernatural beings and epic adventures, and none held my attention like the story of Zeus.

As the king of the pantheon, Zeus held dominion over the sky: At his command were thunder, lightning, rain, and the winds. His most feared weapon was the thunderbolt, which he used (according to some accounts) to overthrow his father Cronus and the Titans, after which he divided the universe between himself and his brothers, Poseidon and Hades.

Early Greek citizens believed thunderstorms on Earth were the manifestation of cataclysmic struggles in the heavens, and images of a furious Zeus hurling thunderbolts at his enemies provided explanation for the mysterious flashes of lightning streaking against the darkened sky. These myths made the astonishing sights and sounds of a thunderstorm comprehensible.

Today, we know thunder and lightning are perfectly natural phenomenon that can be explained with a fairly basic comprehension of physics and our atmosphere. Interestingly, however, thousands of years after the ancient Greeks, we haven't moved past our tendency to ascribe fantastic causes to the scary events we don't fully understand.

This was apparent with last week's short-term sell-off in the stock markets, which saw the S&P 500 lose more than 5.4%. In the midst of these investor jitters, the financial media—self-professed experts in the vein of Greek oracles that they are—were quick to provide a publicly satisfying explanation for this scary turn of events: losses in subprime mortgages and tightening credit conditions. Anger the credit god of corporate and mortgage debt, and suffer his wrath!

But just like Zeus as an explanation for thunderstorms, this rationalization for a minor market pullback simply doesn't make much sense if one takes a scientific approach. First, as explained in several prior MarketMinder daily commentaries, neither subprime losses nor tightening credit conditions are material—subprime loans are a tiny part of the mortgage universe, and credit spreads, while higher than earlier this year, remain well-contained (see "Don't Go Blind from the Subprime," 2/20/07 and "Debt Disambiguation," 7/26/07).

In the case of subprime mortgages, there's nothing material that has happened over the last week. Bearish prognosticators have screamed for more than half a year about defaults, and yet the market marched upward to double-digit returns in the first half of the year. Did investors suddenly "wake up" six months into the year, decide the story has some merit after all, and then all go out and sell their stocks? Unlikely.

Second, and perhaps more importantly, most investors simply don't realize the regularity of temporary pullbacks during bull markets. A 2006 study conducted by Ned Davis Research looked at the Dow Jones Industrial Average over the years 1900-2006 and measured the number of small corrections along the way. Over the more than 100 years studied, there were 355 pullbacks of 5% or more—an average of more than three per year. If you are a faithful MarketMinder reader and know the Dow is flawed, you might ask if this is also true of a properly constructed index. The same study looked at the Russell 2000 since 1979, showing 74 dips of 5% or greater, which is just shy of three a year. For both indexes, declines of 10% or more were also routine, occurring on average about once a year. (Keep in mind these were the averages over all years, including very strong years in the market.) So, even in a perfectly healthy bull market, an investor should expect at least a few small pullbacks a year, and likely one correction of 10% or more, none of which indicate anything but normalcy.

Sharp losses can be scary—none of us like to see our portfolios decline so quickly in value. But, just as a loud thunderclap may still startle us, our modern understanding of weather means most of us no longer fear being on the receiving end of a wrathful thunderbolt from Zeus.

If you strive to see the market as objectively as the weather, you'll see there's really not much to fear about last week's losses, either. Looking forward, it's possible the decline in stocks continues for a bit. But, as we've said in the past, bull markets die with a whimper, not with a bang; this pullback has all the makings of a short-lived correction.

There may be a few more cracks of thunder and dark clouds yet to pass, but don't lose hope—they're not punishment from a vengeful god. There's still plenty of sunshine ahead.