The day after a disaster Part 2 1 comments

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Today was truly the Black Monday of 2006; I think it was worse than last Monday when the STI also collapsed by a similar amount. I have not seen a whole clump of stocks being sold down by 15-25% within one day for some time (it happened to the China stocks today).

Now, Part One by the same title was written right after the London bombings in July 05, where I was expressing my thoughts on what market response was likely the next day. Thought that I would use the same moniker with Part 2 appended, although today was more of a market disaster than an actual disaster like 9/11 or the London bombings.

Talk is swirling around the online forums with investors and traders alike talking of cutting losses, especially their most volatile stocks even though these might have corrected drastically. To this I question the reason for doing so, especially if these stocks were bought on the basis of strong fundamentals and good valuation. Of course, if these shares were bought for the express purpose of selling to the next greater fool, then perhaps disposing of them may not be such a bad idea.

Clearly the investor's response to a market disaster should vary from that of a natural/manmade disaster like 9/11. For the latter, the market response the next day is relatively predictable: a sustained drop where the trader should consider selling high-beta stocks at the open (assuming gap-down is not substantial) and seek to buy back later. For the former, one never knows what might happen: the market might continue its downward trend, or it might inexplicably turn around on its head. That is the nature: as suddenly as it collapsed, it might rebound with equal abruptness. So why be whipsawed?

And by the way, no point formulating conspiracy theories for the sudden drop (fund managers pushing down so that they can buy back later cheaply, blah blah). Fund managers are all competing for performance, do you think they have enough trust in each other to coordinate market manipulation operations? Firstly it's illegal, secondly each will be trying to take advantage of any such "cartel"'s agreed position and try to game the system. More likely it's the invisible hand at its cruellest. One thing though: fund managers are not afraid to dump when they sense the market tide turning, hence contributing to a sustained selldown: that's because it's not their money. The thing is, sometimes this is an advantage of managed money, because cut-loss strategies can be executed emotionlessly.

Some chicken soup for the investor's soul: in a falling tide, all boats will sink. But remember that when those boats with holes will sink to the bottom of the sea, what happens when fishermen are looking for boats to use? There will be less supply, and hence rental prices for good boats will be bid up. What my little metaphor says is that in a bear market investors/traders alike start to focus on the risks of the various stocks on the market (instead of blindly buying on themes or momentum in a bull market) and inevitably the wheat is separated from the chaff. This process of natural selection is accelerated in a bearish market and ultimately directs smart capital to good stocks; in the medium to long term, the market learns to allocate capital efficiently and correctly. And hence a market correction, even a sustained one, may not be a bad thing, if you have selected your stocks on the basis of fundamentals and continue to believe that they are undervalued relative to their upside potential.