Breakout

Stock Market Mania: What Investors Need to Know

Breakout

Wall Street is on the cover of every newspaper and will be the topic of every party you attend this weekend -- especially now that the U.S. has seen its AAA credit rating downgraded at Standard & Poor's.

It was an ugly week as fear took its toll on the markets. The Dow Jones Industrial Average dropped 5.8%, the S&P 500 fell 7.2%, and the Nasdaq ended 8.1% lower this week. While the panic level is rising, if you're an individual investor with a carefully chosen basket of blue chip stocks, there are two things you really need to know:

1) Don't ignore your losses.

2) This is not the time to start changing your investment strategy.

Through no real fault of their own, real people lost real money this week. We are now in a market correction. The Dow Jones Industrial Average is down over 10% from July 22nd. Some folks did better than the Dow, and some did worse, but almost everyone took it on the chin. As Lou Mannheim said in Oliver Stone's 1987 classic Wall Street, "It's so bad even the liars are losing money." Closing your eyes and throwing away your unopened brokerage statements isn't going to save your portfolio. Don't be afraid, be aware.

Here's what you have to know about the week that was:

The market has been selling off because of problems in both Europe and the United States. In Europe, the concern is an ongoing contagion related to the collapse of the Greek economy and flaws in the structure of the European Union and eurozone. To boil it down, consider Europe a dysfunctional family, where Germany and France are the respectable parents being asked to repeatedly bail out their reckless children.

In this case the kids are Portugal, Italy, Ireland, Greece and Spain ("The PIIGS"). No one knows exactly what will happen if the economically responsible members of Europe separate themselves from the PIIGS, or even if a separation is possible before an economic collapse.

On the upside, the problems in the United States are relatively simple, at least compared to those of Europe. On the downside, it's still ugly. It's looking increasingly like the U.S. is slipping back into a recession. Gross domestic product (GDP) was below 2% for the first 6 months of this year. And while corporate earnings are strong, company outlooks for the second half have been soft and unknown. In CEO speak, companies have low "visibility." This means that corporate America has no idea what's next and thus won't be hiring anyone or investing in major projects anytime soon. This is a clear and present threat to economic expansion.

Which doesn't even address the fiasco that was the debt ceiling debate. Not since LBJ's "Gulf of Tonkin" incident led to the Vietnam War has a fake crisis done so much damage. There was no crisis, there have been no real spending cuts, and the debt ceiling will be raised again just it has been dozens of times since it was instituted. Nobody "won" the debate, but at least to Wall Street, the debacle confirmed its deepest fear that both parties are entirely out of touch with what America wants and needs. The long-term impact of stimulus can be debated, but the Federal Reserve's quantitative easing measures (QE and QE2) at the very least drove stocks higher. Now the stimulus is gone just when the economy needs it most.

So when you see markets as volatile as they were this week, particularly on Friday when stocks chopped around in a nearly 3% range, it's not because crazy, greedy traders are manipulating markets. It's because nobody knows what's going to happen next. The rally effort on Friday was quickly scuttled when rumors circulated that Standard & Poor's would downgrade the U.S.'s AAA rating -- which of course happened several hours after the close.

That brings us to our second point. This is not the time to make radical changes to your investment philosophy. Despite what you may hear about mysterious hedge funds manipulating stocks lower, the reality is most rational funds simply try to weather sharp downturns without getting hurt. This wasn't the week to decide you're a day trader. Next week won't be a good time to make that career change either.

If you buy blue chip stocks on dips, well, this is a dip. If you keep cash on hand to stick a toe into stocks during a rainy day, you should know that it's been pouring all week. What most pros do is probably what you should do at home: Decide how much you're going to invest, then put that money to work in increments. "Calling the bottom" is a sucker's game. If you want to own stocks, put your money to work gradually.

In all probability, this is a horrible time to call your broker and dump everything, with one caveat. If you can't sleep at night because of what happened in the markets this week, then you are too fully invested. Sell until you can be rational, then pause to decide what to do next.

I'm not giving stock tips, and I'm not telling you to buy or sell as blanket advice. Investing has risk, which is probably something I don't need to tell you now. What I can tell you for sure is this: The best companies in America at the start of the week are still the best companies now. They may or may not be good stocks, but with cash hoards high and dividends being paid, it's extremely unlikely that, say, Procter & Gamble (PG) will cease to exist over the weekend, no matter what happens in Washington, D.C., or Europe.

I can tell you what I did this week. I sold my position in the Gold ETF (GLD) and added 5% to my position in McDonald's (MCD). After I did that, I sat back and watched the drama unfold. Wall Street may not be for the weak of heart, but every once in a while it makes for decent theater. At least if you've done your homework.

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