The Wrong Question and the Right Question About Today’s Market – And How Today Proves It


The Wrong Question is: Is the market going up or down?

I’ve seen a million different dudes on CNBC in the last week arguing for why the market is going to go up or down, as the case may be. 

The guys who see it going up say that nothing about the economic fundamentals have changed.  Goldilocks lives!  We’re going back up. 

The guys who see it going down say that the economic fundamentals have changed.  Subprime mortgages are blowing up.  4th quarter GDP was revised down from 3.5% to 2.2%.  Japan raising it’s targeted interest rate has put a hurt on the “carry trade” (subscription required).  The technicians say that the uptrend has been broken and so now we’re in a downtrend. 

One bull I heard on CNBC today said that the market is going up because it always does during the 3rd year of a Presidential term!

All this points to the conclusion that: nobody really knows which way the market is going in the short term.

Which leads us to The Right Question: What is the current risk/reward equation in the market?

What’s fairly obvious is that something changed in the market last Tuesday.  All of a sudden a very low volatility, mildly uptrending market turned south quickly.  Volatility spiked and panic was in the air.

The market rallied Wednesday and it looked like possibly normalcy had returned.  But the market sold off dramatically at the open on Thursday.  The Dow was down 200 points right off the bat!  Even though the market rallied for pretty much the remainder of the day, this was definitely not normal.  The market was again down substantially on Friday and Monday.  There was a nice rally yesterday (Tue).  Today was looking good until D.R. Horton’s CEO tanked the market with his “sucky” comments

What all this shows is that, regardless of if the market is up or down, the market is a bit skittish right now.  What that tells me is that risk is elevated.  When people are scared, something little like today’s comments by DR Horton CEO Donald Tomnitz can send the market down pretty dramatically.  A couple weeks ago I don’t think those comments would have had nearly the effect they did today.

In other words, while we can argue about whether the potential rewards of investing in the market are higher or lower than they were a week ago (lower prices = higher rewards, lost momentum = lower rewards) what is clear is that the risks of doing so are much higher.  Any bit of bad news, any sell off overseas, and this market is susceptible to big down moves.

Andy Brooks, head of stock trading at T. Rowe Price said this today (subscription required):

After last week’s volatility, even though we had a great day Tuesday, we haven’t healed completely.  People are still very cautious and anxious, so we can be pushed around here pretty easily.  There’s not alot of confidence out there.

Why not play it safe by tilting your porfolio towards quality names that will better withstand any sell-off and raising some cash to buy shares at a lower price in the event such a sell-off materializes?  Even if it doesn’t, you can always buy back in.  This way you risk missing a little upside and alot of downside.  It just makes sense to be conservative here given the new risk/reward equation.

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