Tuesday, June 06, 2006

Five reasons why fear is winning over greed

In the last several weeks, the Dow has plunged 5%. Yesterday it lost almost 2%. What's behind the selling? If you're still holding onto your stocks how do you justify your decision? How much lower will the market need to go before you decide it's time to sell?

As I've said before, I don't believe anybody can provide a convincing explanation of why the market does what it does. While I liked Amey Stone's views on today's market move I think there are additional reasons to be concerned about the market's future.

I see five reasons why fear is winning over greed:
  • New Fed Chief. As Joni Mitchell once sang, "Don't it always seem to go, that you don't know what you've got till it's gone." When Alan Greenspan took his big yellow taxi out of the Fed Chair, his replacement lulled us into a temporary state of complacency. But Bernanke is no Greenspan. While he did well in school, he lacks Greenspan's real world experience. This experience matters because it gave Greenspan the ability to reach outside government statistics to find out what was really going on in the economy. Bernanke's "data driven" approach is scary to the market because nobody knows what data Bernanke is using; whether the data are accurate; or whether he's using early warning indicators or driving while looking in the rear view mirror. All this leads to massive uncertainty about whether Bernanke will keep raising rates.
  • Low presidential poll ratings. Recent polls suggest that the president's approval ratings are in the high 20s. Notwithstanding a few personnel changes, US troops are still in Iraq, the price of gas is still over $3 a gallon, real estate prices are falling, and the president is consumed with amending the constitution. As November elections approach, the chances of a change in leadership look pretty strong. This could throw the situation in Washington into turmoil -- potentially endangering the administration's tax cuts and industrial policies.
  • Geopolitical jitters. Iran still seems to be developing nuclear weapons. Will it be able to drop nuclear bombs on Israel and other places in the next five years? The fear that it might is leading western leaders to engage Iran in some kind of dialog. And today, this dialog led to fears that Iran would cut off its supply of oil if things did not go its way. While the US is trying to create a package of carrots and sticks to make Iran do what it wants, the markets may fear that US only has two real options for dealing with Iran: bomb it or do nothing. Neither option is reassuring to investors.
  • Return to economic reality. For years, whenever someone mentioned the rising Federal budget deficit or the enormous current account deficit, the falling dollar, the enormous debt burden carried by government and consumers, or the over-inflated housing market, Dick Cheney would give a speech saying "Reagan proved that deficits don't matter" and the markets would assume everything was fine. With the low poll numbers and high gas prices, investors are beginning to realize that stagflation might be the result. And the scariest thing of all is that raising interest rates might not be the right solution for stagflation.
  • Need for new solutions. Raising interest rates will certainly lead to higher mortgage rates and higher credit card interest rates. The higher mortgage rates will contribute to a decline in housing prices and an increase in mortgage defaults. The higher credit card rates will crowd out some portion of consumer spending that might have gone to purchasing clothing or toys. However, higher interest rates will have absolutely no impact on the price of oil which is acting as a tax on consumers and businesses. So Bernanke has a blunt instrument which will not solve the economic problems we face. This calls for new solutions and it's unclear who will deliver them.

I think investors should have stop losses in their accounts. If a stock declines more than 2%, I think they should sell. If your portfolio is comfortably above water, it may make sense to wait out this dip -- but it could be a long wait.


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