Pray for Panic

Feeling anxious? Plagued by nausea or cold sweats? Rest assured, those feelings are perfectly natural. In fact, pray for more market wig-out.

We don't want you, dear reader, to suffer. But in aggregate, we welcome market panic. The bigger, the better. A bigger freak-out means more volatility and a bigger bounce off the bottom—all leading to bigger market returns for the year.

The best recent example was the correction of 1998—the roots of which were anchored in 1997's "Asian Flu" and sealed with 1998's "Russian ruble crisis." The now infamous Long Term Capital Management (LTCM) had highly leveraged itself seeking outsized returns from fixed-income arbitrage bets on world government bonds. LTCM's fixed-income bets started going against them in the summer of 1998, and because the fund was so highly leveraged, the implosion was sudden and massive. (We don't much understand a strategy in which the potential payout doesn't merit such an inappropriate amount of risk, but we digress.)

If you think people are panicking now, this is nothing compared to the fevered derangement of Summer and early Fall 1998. Investors were convinced the entire world was infected, and panicked. Folks who previously couldn't tell a peso from a ruble were suddenly convinced this little currency had the power to sink the world. They had the evidence—LTCM's failure!

All year, the S&P 500 methodically climbed, with little interruption, to a pleasant 22%. Then beginning in mid-July, the market plummeted 20% within 6 weeks, erasing the year's gains in a soul-crushing blink—signaling the End of Days as assuredly as frogs raining from the heavens.

Yes, the Asian flu and Russian ruble crisis roiled world markets. Yes, LTCM managed about $129 billion in assets (most of which were borrowed—oops—net equity was a mere $4 billion). But $129 billion was a small part of the much bigger financial sector, a speck in US capital markets, and utterly meaningless to world capital markets. After investors tired of Russian ruble headlines, they very sensibly noticed the economy was doing just fine and earnings were strong, and the market melted-up to finish the year a net positive 29%. (A net annual return of 29% is what we might categorize as "awesome.")

The big freak-out provided the volatility needed for a huge, end-of-year surge. Smaller freak-outs, like this and last years' yen carry trade kerfuffles or 2005's Asian bird flu fears, have smaller surges. You need the massive emotional melt-down to get the massive melt-up. The bigger the kid on the trampoline, the higher he'll fly.

If that doesn't provide comfort, remember corrections and bear markets do not begin the same way and feel vastly different. (Read MarketMinder commentary "Corrective Measures," 08/03/2007.) Corrections run on emotions, but bull markets run on fundamentals, like these positive drivers:

1. The US and global economy continues to grow—a healthy 3.4% in Q2. Yes that number will be revised, possibly down—but it's far better than expected—and the world is growing faster!
2. Stock supply has been and will continue to be reduced through cash-based M&A activity, driving prices higher. Sure, the high-yield market has hit a rough patch after a terrific run, and private equity deals may back off their record-setting pace. But the fundamentals fueling this activity remain intact, and once jitters ease, CEOs will be back at it. (For a review on cash-based M&A's impact on stock supply, read MarketMinder commentary "Smart, Smarter, Smartest," 04/24/2007.)
3. Earnings will likely surprise to the upside. They have to. Why? Because the economy is stronger than expected, but also, no one is accounting for the stock supply reduction here in the US. The same (or increasing!) earnings spread over fewer shares means earnings-per-share will rise.
4. Interest rates remain benign. Read that again. Despite all the hysteria, the 10-year US Treasury rate is back around 4.75%. A few months back when the rate hit 5% and higher, folks fretted the end of the bull. Why invest in stocks if long-term rates are going to ratchet to 6% and 7%—risk free! But rates never got that high, and have since fallen. (Oddly, no one who keened the bull's death at the hands of moderately higher rates is now saying, "Phew! Everything's OK.") Today's low rates are making stocks look exceedingly cheap, relatively. And, no matter what front pages squeal, money remains darn cheap.

The current hysteria has all the markings of a true correction. It came out of nowhere, fueled by a big story (melting credit markets) that we'll later see as no big deal. Investors will eventually (and probably, shortly) realize, unless they manage a hedge fund focused specifically on trading CDOs on margin, such a small portion of the credit markets doesn't impact them much at all. (If they are such a manager, things might be kind of rough for awhile. But hey, unemployment remains low. They can likely get a nice job as a management consultant or something.)

In the meantime, let the panic continue and pray for it to get bigger. Now's no time to abandon your stocks—the bounce off the bottom will be worth the ride.