Is it safe to go back in the water?

Investors around the world are no doubt continuing to ask this question as we approach the one-week mark since that megadip roller coaster ride the US equities markets went on for about 30 minutes last week.  If you had gone out for a late lunch on the East Coast last Thursday you would have missed the sickening 900+ point plunge in the Dow (or lost your appetite if you happened to check your BlackBerry during the meal).  A week later the whole episode has a sort of surreal quality about it: a vibe of optimism pervades the markets again as the Dow ascends back towards the 11,000 level it reached last month, but that candlestick chart for May 6 reminds us that things may be more fragile than they sometimes seem.  Regulators and experts are still trying to piece together exactly what happened: what combination of actual news, hedge fund trade orders, data errors, general psychology and other factors combined to suck share prices into that death-defying vortex and then right back up again?  For seasoned traders and investing novices alike there are perhaps some instructive lessons here about dealing with the short-term.

At any given time there are numerous actual and potential events taking place that, alone or in combination with others, have the potential to disrupt markets.  If we sat down and made a list today we could probably come up with over 500 macroeconomic, geopolitical and socio-cultural factors that on any given day could trigger a market rally or a huge selloff.  That would only be the tip of the iceberg – things we could actually articulate, as opposed to unseen variables randomly popping into and out of existence like so many quantum particles.  The problem with trying to translate the impact of these variables into short-term market tactics is that we never know which ones are going to have an impact, when they will have an impact, and how the market will ultimately react.

Clearly on May 6 the debt crisis in Greece and its impact on the EU/world at large was weighing on equities markets.  European and Asian markets were down and Wall Street quickly moved into bear territory.  Greece’s woes were nothing new, of course, but traders were weighing the uncertainty of a sufficient EU and IMF plan to address the crisis with an approaching sovereign debt payment date in mid-May.  Investment markets hate nothing more than uncertainty.  What would the implications of a Greek debt default be on other weak Eurozone economies like Portugal, Spain and Italy?  Was the Euro itself at risk?  Could this be the start of another credit crisis that would ultimately throw cold water on the gingerly recovering global economy?  For whatever combination of reasons, May 6 was the day when all this swirling uncertainty coalesced into a direct hit on the markets.  As we noted earlier, the actual magnitude of the market’s reaction was some percentage mix of hard news, psychology, systematic trade orders and actual or imagined data/computer errors.

Over the weekend the EU and the European Central Bank (ECB) moved swiftly and cobbled together a much bolder and more audacious plan than observers generally had expected, leading to a Monday where the “good kind” of volatility reigned, i.e. the upward-moving kind.  By addressing the liquidity concerns of financial institutions with exposure to Greek and other dicey EU debt, the rescue plan announced on Monday significantly eased near-term uncertainties and allowed traders to resume focusing on the stronger-than-expected economic recovery in the US that has generally been lifting stocks for much of the past two months.

What investors need to remember, though, is that days like May 6 will happen again – that’s about as close to a sure thing as exists in financial markets.  Greece will in nearly all likelihood make that May 19 debt payment – but the EU rescue plan does nothing to address the country’s ongoing solvency problems, nor does it ensure any kind of happily-ever-after tale of economic growth and domestic political stability in countries where bracing austerity measures are not likely to be wildly popular.  And lest we forget, the misfortune in the Mediterranean is not the only variable out there we have to fear.  Greece’s debt-to-GDP ratio currently stands around 133%.  By contrast Japan, a $5 trillion economy, has a gross debt-to-GDP ratio of 197%, not to mention a terrible demographic outlook, chronic deflation and a dysfunctional government.  That’s not creating shock waves in the market today, but who is to say what impacts – or doesn’t impact – prices tomorrow, six months or two years from now.

In the short term, expect the unexpected.  Be prepared for volatility that arises seemingly out of nowhere like a sudden tempest on a clear day at sea.  Think carefully about your investment time horizons and how prudently they are aligned with the risk levels you are assuming in your portfolios.  Use long-term historical returns as a guidepost – but never assume that those returns will be guaranteed for your own planning purposes.  Investing lends itself to extreme expressions of human emotion – but it is the disciplined investors who can keep their emotions in check who will prosper in the long run.