What to do During a Market Adjustment

I know Americans are concerned about the adjustments that are taking place in our financial markets.” – President Bush


What on earth is a financial market “adjustment?”

Despite the sugar-coating, President Bush did get one thing right – Americans are concerned. More like afraid. Fear has taken over the markets. I’m loving every second of it, and you should be too.

The U.S. economy has plunged into recession. Unemployment has surged more than 50% in the past two years. Multi-billion dollar investment banks like Bear Stearns (BSC), Lehman Brothers (LEH), and Merrill Lynch (MER) that leveraged themselves against the housing market have disappeared, (Goldman Sachs (GS) and Morgan Stanley (MS) may be following soon). Government sponsored enterprises Fannie Mae (FNM), Freddie Mac (FRE), and IndyMac (IMB) have been completely wiped away.

All the bad news has sent the major indices tumbling into bear market territory. Inexperienced investors are starting to feel helpless – and they’re starting to take action.

In July, investors pulled $23 billion out of stock mutual funds. In August, the sell off continued when mutual fund investors pulled out an additional $6.5 billion. The mutual fund redemptions undoubtedly just worsened the market’s decline.

When investors want their money back, mutual funds have to pay up. Normally they have plenty of cash on hand. However, when a lot of investors want their money back, as we’ve seen over the past two months, they have to sell shares to get the cash needed to pay back investors.

This is good news, though.

As a whole, mutual fund investors put money in and pull it back out at the worst possible time. The tech bubble is the perfect example. In 1999 and 2000, money flowed into technology-focused mutual funds. At the peak of the tech bubble in March of 2000, about 80% of all money in mutual funds was in the technology funds. All of that new money pushed the Nasdaq to a peak of more than 5,000.

When the downturn came, which it always does, the leading technology mutual funds lost 60% to 80% of their value as the Nasdaq plummeted back to 1,000. Moreover, most mutual fund investors weren’t selling out along the way.

Mutual fund investors waited and waited for a rebound to come. In typical fashion, most were unwilling to give up hope and take a loss at first. However, after the Nasdaq slid lower and lower each day over the next two years, they began to sell out.

As usual, they were selling at the worst possible time. In 2002 and 2003, when the major market indices were bottoming, mutual fund outflows were at their peaks.

It’s all just proof the herd is usually wrong. They buy at the top and sell at the bottom. That’s why I consider the recent surge in mutual funds redemptions a good thing.

Over the short-term, it just adds to the selling pressure in stocks. Over the long-term, it means there is a light at the end of the tunnel.

Although I expect more bad news from the financial sector, it’s tough to imagine it getting much worse. After all, when every forecaster is predicting “another shoe to drop,” chances are the markets are prepared for it.

So, I don’t think the end of the sell-off is over by any means, but I also don’t believe we’re headed for financial apocalypse. Over the next 12 months we’re going to get a lot of bad news and towards the end, we’ll start getting a bit of good economic news. There will be violent swings in the market along the way, but eventually, they will end. They always do – eventually.

In cases like this, when every pundit is calling for a crash, I try to step back and look at history. If you consider a bear market a drop in the Dow of 15% or more, there have been 25 bear markets in the past 110 years. Most of them have lasted between 12 and 24 months, and the average decline was between 20% and 40%.

If we consider this bear market started last October when the Dow last hit 14,000 we’re probably looking at between one and 13 months and possibly another 10% or so until we hit bottom.

The best possible thing to do now is learn to love bear markets. It’s the only time almost every stock goes on sale. And that’s the best time to buy.

Of course, I don’t recommend going “all in” today. Trying to time a bottom can be disastrous. However, right now, it’s more imperative than ever to have a plan.

I’ve set aside enough cash to buy consistently each month for the next 24 months. A 24-month plan should be exactly what is needed to make it through this bear market.

After all, right now there is a ton of money sitting on the sidelines. While investors have been bailing out of mutual funds as fast as possible, an additional $44 billion has flowed into money market funds with their brokers. As of August, a total of $3.5 trillion is sitting in money market funds.

The herd has moved into safe money markets in a big way. Once the markets start to show some signs of life, a big part of those money market funds will come back into stocks. It always does.

During “market adjustments,” when it seems like buying stocks is the worst thing to do, chances are it’s the best thing to do. As long as you have a plan (and stick to it), you can learn to love bear markets too.

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