Stock Market Capitulation

The stock market seems to have periods when it acts somewhat logically and periods when it acts on pure emotion. When logic goes out the window and emotion is the driving force then the market it at a top or at a bottom. When it market reaches the bottom it is called capitulation or the point when investors give into emotion and essentially throw in the towel.

How can you tell when capitulation occurs? Here are 5 signs:

1. Wild swing during the day. The events of October 10th represent this nicely. The Dow opened down big and kept going down which means that people were selling just to get out and in the afternoon a large rally happened where institutional buyers saw it as a golden buying opportunity. A previous blog indicated that this looked like a market bottom and it was time to buy. October 10th gave us the largest 1 day price swing in the history of the Dow. It was massive selling by people who had finally had enough and emotionally had to get out.
2. Another sign is when the common belief is that it is going to keep going down and any sense of reason is discarded. For example, on Monday November 24th, when the Dow was about 8,000 CNBC reported that about 70% of people who responded to a survey question thought that the Dow was headed to 6,000. Now many experts have said that now was a great time to buy. However, the people who are investing based on emotion have an underlying belief that it will keep going down regardless of the number.
3. When you read it in the newspaper that long time investors have quit. For example, the Monday November 24th Wall Street Journal had an article: "Fear and Frustration: Some Investors Quit." The article gave examples of people who had been long time investors in the stock market and finally could not take it anymore and walked away.
4. When bad news occurs and the market keeps going up. The news in the Tuesday November 25th Charlotte Observer was that home sales had fallen more than expected in October. On Monday November 24th it was reported that existing home sales dropped on average 3.1% nationwide during the month of October. In the past, news like this would have send the Dow tumbling down. In spite of this news the Dow rose.
5. When you are tired of hearing about it, can not turn on the news, and physically feel sick to your stomach. This is a good indicator that you are at the point of capitulation and the question is will you capitulate or not.

What does this mean? If you have not already changed your investments to prepare for a recovery in the stock market now would be a good time to do it. A recovery always follows capitulation.

Basics of Investing in Bonds

A balanced retirement portfolio usually contains some exposure to bonds in the form of a bond mutual fund. I found this article on bond mutual funds written by David Pitt, it gives good basic information for consideration.
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The type of bond fund you choose depends in large part on your financial goal. You need to first ask yourself whether you're seeking safety with little growth or more robust growth at higher risk. While they are safer investments, it's a mistake to think that bond funds are entirely without risk. Government bond funds, for example, have performed very well compared to other stocks and bonds this year and are considered relatively safe investments.

A Morningstar analysis shows that year to date, short-term government bond funds have earned an average of 2.6 percent and long-term government bond funds, averaged a 1.9 percent gain. In the same time frame the various categories of domestic stock funds have lost on average between 27 percent and 55 percent year-to-date. What's more, investors who earlier this year moved from equity funds into bond funds -- which have significant holdings in corporate bonds -- were able to stem some of their losses. Short-term bond funds are down 4.1 percent and long-term bond funds are down 11.5 percent so far this year.

So, you need to decide how much risk you're willing to take to determine which type of bond fund you want to choose as part of your portfolio. Fidelity Investments offers tips on how to choose bond funds.

If you're planning on investing for a year or less, a short-term bond fund may give you a better return than a money-market fund but you must be willing to see your investment fluctuate daily with market conditions. If you have more time to invest and a desire to earn more, you may want to look at intermediate- or long-term bond funds. These funds invest more heavily in higher yielding, lower-quality corporate bonds, which are higher risk. All of these choices require you to know your risk level, which may have changed with double-digit losses in your retirement account. If you can't stand losing some of the money you put into your account, many financial advisers would say a money-market fund might be your best option.

If you can tolerate losing some of your initial money and are willing to trade a little risk for higher reward, then an investment grade bond fund might work for you. The key to investing for retirement even now is not to panic and have a plan, said Jack Thurman, president of BKD Wealth Advisors, a Springfield, Mo.-based wealth management company. Unless you're within a few years of retirement, he said you should have one year's worth of expenses in savings outside your retirement account and the rest should be invested to earn as much as possible.

Millions of workers, scared by the falling stock market have taken their money out of stocks and stock mutual funds. TrimTabs Investment Research, which tracks the flow of money in and out of various funds, said through early November stock mutual funds have seen an outflow of $145 billion and international funds have shed $73.5 billion while bond mutual funds have seen an inflow of $83.2 billion over the same period.

Though the talk is of a deep recession, market watchers are increasingly discussing whether now is a good time to buy stocks because prices are so depressed. Of course the potential length of the recession is unclear, but if you're in this age group, you don't want to be on the sidelines with cash when the market surges upward. Once stocks begin to regain their strength, recovery can happen fairly quickly and if you're retirement plan is properly allocated -- many advisers recommend 60 percent in diverse stock funds and 40 percent in bonds -- you should take advantage of the upside. If you're just a few years from retirement you should have a conservative asset allocation. That means heavier investment in bonds and fewer stocks. If possible, resist the temptation to take more money out of the stock market because you'll probably need to take advantage of the market improvements to recover some of your losses.
Keep in mind that bond prices typically react opposite interest rates. When interest rates go up, bond prices likely fall and falling interest rates send bond prices higher. The current environment has also shown that bond issuers can default and fail to make payments.

One of the drawbacks to bond funds is that they may fail to keep up with inflation and therefore are often used in combination with higher yielding funds to offer portfolio balance. Fidelity advisers say it's a good idea to look at the quality of the bonds in the fund, whether they are investment grade or junk status. Those rated below investment grade (S&P rating of BB or lower) could change more suddenly if the credit quality of the issuer changes.
One more thing to look at is the expense ratio.

Morningstar says its more important to look at the cost of a bond fund, because bonds earn less over time than stock funds they're costs are a heavier burden. Morningstar believes very good bond funds are available with expense ratios of 0.75 percent or less.

Modern Portfolio Theory and the Last 13 Months of Investing

I wrote about the Modern Portfolio Theory in a previous blog. The theory can be summarized by a series of risky investments when combined together yield a greater return with a much smaller amount of risk such that you can approach the return of a risk free investment like a short term treasury bond.

Money moves between investment classes such that wealth is re-allocated rather than be destroyed. Money moves between asset classes such as commodities, US stocks, International stocks, long term bonds, short term bonds, etc...

What I learned during the last 13 months from October 2007 - 2008, when the Dow declined by 44%, was that this theory worked well until June 2008. For the first 9 months things acted normally and diversification worked well. From July through October the theory failed miserably.

In hind sight my blind faith in this theory cost me a lot of money. What I failed to realize is that when things go into a panic and fear abounds the only save place to be is in cash or a cash instrument like a money market account.

From July through October virtually all asset classes crashed. Wealth did not transfer it was destroyed in every class. Long term bonds dropped 25%. Short term bonds dropped 10%. All commodities dropped even gold. All stocks indexes around the world dropped.

Diversification works for 95+% of the time. I believe that diversification is the prudent course of action now. For the other % of time when panic hits it is time to put the theory aside and get in a position to buy at the peak of the panic when few others want to buy.

Be fearful when others are greedy and be greedy when others are fearful.