Find Today's Stock-Market Surprise
Markets were under intense pressure earlier today, with the Dow Jones Industrial Average down almost 400 points. Most indexes were down 2 percent or so around the globe before recovering some of the losses.
As is often the case during big market swings, numerous narratives attempt to explain the causes of the market turmoil. Consider the following headlines:
The only genuine surprise on that list was an unexpected drop in durable goods orders of 3.4 percent in December.
Let's take a look at the “news” that supposedly drove today's stock market.
Caterpillar missed fourth-quarter earnings expectations and lowered forecasts for the coming year on (surprise!) plunging energy prices and slower European and Chinese sales . Procter & Gamble blamed lower earnings on the stronger U.S. dollar (shocker!), while Microsoft said that software-license sales for PCs declined (who ever could have seen THAT coming?).
In other words, all of the major announcements were based on issues that were both well-known and well-understood. I am hard pressed to believe that much of anything else in those headlines shaved 2 percent off global markets.
The market isn't perfectly efficient -- it is mostly, kinda, sorta, eventually efficient -- but it also isn't a complete idiot either (at least not most of the time). All of these issues should already have been reflected in stock prices. If not, Eugene Fama may have to send his Nobel Prize back to Sweden.
The simple reality is that much of the day-to-day action in markets is unpredictable, random noise. It is a simple truism that we don’t know what tomorrow will bring and, regardless, have very little control over the outcome of what might happen. This lack of knowledge and control makes us very uncomfortable -- hence, the human tendency toward emotionally driven actions in the face of market volatility, whether it is to the upside or the downside.
Since it is a fact of life that we don't know the future and can't control outcomes, then what can we do? In my book, there are at least three steps that you can take to reduce the impact of days like today.
First, understand this is inevitable. Two percent swings occur fairly often. If we are long-term holders of various asset classes, than unpredictable price swings are a fact of life. You can limit the stress of days like this by reducing your risk assets (and in all likelihood, your returns). Understanding the mathematics of mean reversion and valuation helps as well, as does weighting your holdings toward less expensive assets.
Second, it means coming to grips with your own emotions. Avoid the very real tendency to do very stupid things at precisely the wrong time.
Third, it means having some sort of game plan. The time to find the emergency exit is when the plane is on the ground, not at 30,000 feet with the engines on fire. If you can't tolerate the volatility, then you need to incorporate that into your thinking before trouble hits.
You do have alternatives to these three ideas: You can follow tortured narratives that make you feel good, even knowing they provide misleading or false explanations. But I wouldn’t recommend it.
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