Stocks Lose $4.3 Trillion: What To Do

Stocks have lost 15% of their value since July 21st's near-term Dow high of 12,724 -- amounting a loss of around $4.3 trillion. And they look like they'll fall further. What should you do about it?

The first thing to consider is why stocks have been plunging. After all, if you know the cause, you might be able to get a handle on whether stocks will keep falling or turn around. Regrettably for the average investor, there is no credible way to explain what caused stocks to lose 15% of their value.

That is not to say that people are not offering explanations, it's just that there is no evidence to back up the claim that there is a cause and effect relationship between those drops and the supposed causes. Here are a few examples:

• S&P downgrade. The idea here is that S&P's downgrade of U.S. debt caused stocks to crash. Of course, stocks have been plunging since July 21st and that downgrade happened on August 6th so that could not be right. On the other hand, it would not shock me if rumors of an imminent downgrade hit the hedge funds last month and many investors sold their stocks in anticipation of general investor panic. But so far, there is no proof that this is what happened. Meanwhile, S&P's downgrade has had exactly the opposite affect it intended -- investors are pouring money into 10-year treasuries, dropping the interest rate they charge us by 27% in the last month.
• Double-dip recession. Concerns about another recession certainly gained steam when the Commerce Department reported a big negative adjustment to first quarter GDP growth (up 0.4%) and a dismal second quarter report (+1.3%). But that happened on July 29 -- so unless that report leaked eight days earlier, it probably does not explain the stock market plunge. If GDP growth does go negative, it might result in lower earnings growth and undermine stock valuations.
• European debt troubles. These troubles have been going on for at least a year -- with Greece, Portugal, and Ireland bringing down the financial prospects for the European Union. There have certainly been new twists and turns -- including potential problems with Italy and Spain and even rumors of a downgrade of France's credit rating. While this uncertainty contributes to stock price fluctuations, there is nothing fundamentally new since July 21st.

In short, nobody can explain why stocks have lost 15% of their value in the last several weeks. The good news here is that there are people who do know -- they are the managers of huge pools of money that are either selling stocks or betting that they'll drop.

The bad news for the average investor is that those money managers are not disclosing the reasons for their decisions. One relatively small player, Barton Biggs, called U.S. equities a “strong buy” just last week, according to Bloomberg. But as a manager of $1.4 billion Traxis Partners LP, he is taking a risk off posture.

His comments reveal how he thinks about stocks -- they should go up based on their valuation relative to earnings growth and he is selling them because everyone else is and he can't afford to be wrong in the short-term about stocks' direction. As he told Bloomberg TV, “I’ve taken some risk off, and I hate to do it, I think it’s probably the wrong thing to be doing. But I’m a fiduciary to a certain extent, and I’ve got to protect my capital.”

So what should you do? That depends on what you think will happen next and your financial condition and cash needs. To further this discussion, let's assume two possible scenarios about what will happen next and describe three scenarios of your possible financial condition and cash needs. Using this oversimplification, we'll look at what you ought to do.

Here are two scenarios of what happens next:

• Pessimistic: stocks fall 10% and keep falling for years. Under this scenario, the selling panic continues until stocks are down another 10% from here. Then the combination of a the lost wealth effect -- people feeling poorer due to stock market losses -- and years of cuts to government spending cause a deflationary spiral. This would mean companies shrink -- leading to lower demand, more layoffs, and earnings contraction. Stocks continue creeping downward on light volume for years.
• Optimistic: stocks fall 5% more and bottom out. Here, investor panic results in a further 5% decline in stocks after which people buy stocks with strong earnings prospects and low valuations. This results in a gradual rise in stock prices -- helped by a panic as investors who have bet on a decline are forced to buy shares to repay the loans they took out to fund those bets. Stocks recover and go up as the stock market P/E of 12 rises up to meet the 19% earnings growth forecast for 2011.

Now let's look at three possible scenarios for your financial condition:

• Getting by. If you have limited savings and are just keeping up with your monthly bills, then these scenarios don't matter much to you. Instead, you are likely to benefit from the big drop in oil prices -- West Texas Crude fell to $75.71 -- the lowest since Sept. 2010 -- that should send gasoline prices down. Your biggest concern might be keeping the paychecks coming in -- because under the pessimistic scenario, the odds of you losing your job would go up. Thus you should see if you can cut expenses and start saving.
• Need cash soon. If you have savings but you need a big chunk of them soon to make a down payment on a house or pay college tuition, then you may need to decide whether you should draw that check from your money market or bank account or whether you should sell stocks to raise the cash you need. The answer here depends on whether you think the scenario: if you buy the pessimistic one, then you should sell stocks if you're optimistic, then you should use mostly cash and some stock.
• Patient. If you have savings and don't need to write any big checks in the near-term, then you have more options. These options include doing nothing, selling or buying stocks, buying gold or buying bear ETFs. What to do here depends on which scenario you like. If you're pessimistic, sell stocks, buy gold and bear ETFs -- such as Direxion Daily Finan. Bear 3X Shs (ETF) (NYSE:FAZ). If you're optimistic, do nothing now and wait until the selling panic subsides before buying stocks -- if you're interested, here are three.

In past panics, I suggested that it is better to remain calm than to act rashly. To do that, find a way to relieve stress -- exercise works for me -- and think clearly about your options.