Monday, September 8, 2008

Why did the market finish higher on Friday?

On Friday it was reported that unemployment hit 6.1 % the highest level in five years as employers cut 84K payrolls. The SPY, DIA and QQQQ’s all opened lower and proceeded to lose even more ground as selling accelerated. Oil declined as well, which was not a positive, as it dragged down oil related stocks like XOM, CVX and BP down with it. But somehow, despite all the gloom of the deepening of the recession and higher unemployment, the stock market finished the day in the black.

Sometimes fundamental investors like me forget that the market is a manic depressive individual who defies any logic. Most of the times the stock market is driven not by the cold blooded facts but by the expectations of its participants. Just because I believe that I shouldn’t pay more than 20 times earnings and that dividend paying stocks are superior investments to non dividend paying stocks doesn’t mean that I will be right all the time, or even half of the time. The stock market can continue going higher or lower for whatever amount of time it chooses to. The internet bubble of the late 1990’s serves a great example for that as many stocks defied gravity even when they had no real tangible value or any earnings generation ability behind them. In order to succeed at investing, one has to forget the speculative urge to “adjust” their exposure any time the market ticks up or down. The sentiment and expectations of the players is really what moves the stock market quotations every day not fundamentals.

That’s exactly what had happened Friday- most bearish speculators simply decided to keep selling because their interpretation of the 6.1% unemployment rate was ultra bearish. The market kept on falling, until there were no more weak hands – and the few buyers left at the time propped the market higher. Historically speaking this happened on a larger scale in September 2001, when the attacks on the World Trade Center lead to a massive sell off in equities around the globe on fear that terrorism will further shake the confidence in the economy. Incidentally this was one of the best times to purchase good quality stocks at bargain prices. Other good times to purchase stocks was after the 1987 crash and after the 1997 - 1998 Asian and Russian crisis. It pays to be a contrarian and not follow the crowds.

Successful investment requires that one has a sound investment strategy to identify attractively valued securities. The second component of this strategy however is that successful investors have to wait for the right moment when the crowd’s expectations about the future turn into panic selling in order to step in a purchase the attractively valued securities at bargain prices. The third component, holding for the long run is the toughest, as it is against the basic human instinct that doing nothing could actually be productive.

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