Beware of the Stock Markets

The Dow Jones Industrial Average had its best day ever, jumping 936 points or 11%. This doesn’t make you an idiot for not throwing all your money into the stock market on Friday. Such a move would’ve been an attempt at market timing and it is a dangerous game. Market timing is the stock market equivalent of playing roulette and putting all your chips on one number. Okay, so it’s a little different.

Why Do the Stock Markets Fluctuate?
Stocks reflect expectations. Finance theory says a stock reflects today’s value of all the money that a company will make (after paying its bills) in the future. On a given day, if the future looks brighter than we thought yesterday, the stock will go up. In the last few weeks, due to freezing credit markets and evidence of a deteriorating economy, the outlooks of almost all companies fell. And so did their stocks. But stocks often get oversold, presenting strong buying opportunities.

Why Do Stocks Get Oversold?
The most common explanation is panic selling. Let’s take you for example. You see your 401k plan fall 25% and you’re feelings get hurt. You don’t want it to fall further, so you instruct your 401k administrator (e.g. Fidelity, Blackrock) to take your money out of stocks and put them somewhere else (e.g. cash, money markets, bonds). You’re not alone; millions of people do this. Even rich people were doing this; hedge funds have been reporting all kinds of problems because their investors wanted their money back. All this asset reallocating involves forced selling, and then stocks fall even further causing more panic.

A lot of people argue that stocks initially fell on weakening expectations, but they fell way further on panic and emotions. This is when level-headed investors like Warren Buffett start investing. In fact, Buffett very recently poured billions of dollars into Goldman Sachs (GS) and General Electric (GE).

Why Were Stocks Up So Much Today?
Simply put, today’s outlook was better than Friday’s outlook. In their continuing efforts to unfreeze the credit markets, global governments over the weekend opened the floodgates of cash injections, backstops, bailouts, and insurance. I’m sorry, but even I can’t keep up with what’s being offered. Credit may be unfreezing as banks seem to be lending to each other a little more (as reflected by lower LIBOR rates). One bank (Mitsubishi) invested a ton of money in another bank (Morgan Stanley); that suggests some banks aren’t afraid of catching STDs anymore (see my previous posting).

What Don’t We Know and What Do We Expect to Know?
Well first of all, the banks and the credit markets were closed today in the U.S. (Columbus Day) and Japan (Health and Fitness Day). As such, we don’t know for sure how they’ll react to this weekend’s news. And remember that $700 billion bailout plan that everyone was talking about? That still hasn’t been put into play.

Again, stocks reflect expectations. Stock investors expect U.S. and Japan banks to respond positively to this weekend’s news. Stock investors also expect the $700 billion bailout plan to work to at least some degree.

How To Play This Market
If you’re convinced we’re near a bottom, then it’s still not too late to start moving money into the markets. To put things into perspective, the Dow is down 34% from a year ago. On Friday it was down 41%. However, you should invest a little bit at a time over a period of time (i.e. dollar cost averaging). And make sure you’re investing money that you won’t need within the next two to ten years. Most experts and investors aren’t convinced the stock market will just shoot up; if this were the case—trust me—the Dow would’ve closed much, much higher today. Uncertainty put a ceiling on the stock markets today. And uncertainty translates to volatility.

Before You Go…
There’s still a lot of news to come out. Some of it could be bad sending stocks down. At this point, expectations are so low that even no news would be good news. We’ll see.