Being Street Smart 7/22/6

BEING STREET SMART
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Sy Harding


THE VOLATILITY CAN BE DANGEROUS!
July 21, 2006.

After several years of low volatility and a mostly flat overall market, normal day-to-day volatility returned to the stock market early this year. It presents quite a difference for those given to watching the market on a daily basis, a difference that can be costly if the excitement of big day-to-day moves in either direction are interpreted as changes in market direction, rather than just volatility.

Representative of the volatility, exciting triple-digit daily moves in one direction or the other by the Dow have become routine this year. For example, the Dow ended the week before this with three triple-digit down days in a row, which resulted in one of the ugliest weeks in a number of years.

However, as has also been happening with regularity, there was no follow through. The Dow was back up three days in a row to begin this week, with the third day being a triple-digit move to the upside, a gain of 212 points on Wednesday. But, so far anyway, once again there was no follow through to that triple-digit move, with the market back down the final two days of this week.

Volatility is great, even necessary, for short-term traders. However, until they get used to it again, volatility makes it very easy for investors buying or selling for the longer term to be repeatedly whipsawed, convinced that an exciting big one or two-day rally marks the end of the market correction that began in early May, and a few days later convinced by a return to the downside that the correction has further to go after all. It can easily result in emotionally bailing out at the short-term lows, and jumping back in at the short-term highs.

The financial media does not help. Made immediately pessimistic by big one or two-day plunges, the media rushes to explain all that is wrong with the economy, interest rates, inflation, international situations, and the like. The declines in individual stocks are emphasized, and a degree of panic seems to set in. If a week later a big one or two-day rally takes place, like the triple-digit gain of Wednesday, the media’s immediate knee-jerk reaction is that the market’s correction is over, and the next up-leg is underway.

So volatility can be a problem, causing investors to jump in and out of the market, without regard to what their longer-term expectations are for the market.

My own expectations for the market have not changed. It has three weights on its back, any one of which have been enough to drive the economy and stock markets down in the past; high energy prices; rising inflation (and therefore rising interest rates); and a real estate bubble that is in the early stage of busting.

Those problems are not going away any time soon. They are not even improving, but worsening.

Oil prices hit yet another record high last week ($77 a barrel). The short-term pullbacks that have taken place after each new record high was hit, at $40, $50, $60, $70, $77, have not changed the fact that the longer-term trend has been inexorably higher since late 2002 when military and terrorist actions in the Middle East began creating worries in the oil markets. And few would claim, especially after the events of the last two weeks, that the situation in the Middle East is improving.

On inflation and interest rates, while the markets and the Federal Reserve would love to see signs that the Fed’s 17 interest rate hikes are finally bringing inflationary pressures under control, the Producer Price Index and Consumer Price Index, released this week, both showed inflation in June rose even more than economists had forecast.

On the busting real estate bubble, the real estate industry, which had been in denial, is beginning to acknowledge its problems are more severe, and will be longer lasting, than was expected. Inventories of unsold homes and condos are spiraling upward even as mortgage rates reach four-year highs, and price cutting has begun.

Yes, the stock market looks ahead, and responds to what it expects economic conditions will be six to nine months in advance. However, I suspect it will not be able to look through the current negatives to anticipate better conditions until later this year. Until then it will be looking ahead to a worsening economy.

Once again this week, the market action did nothing to change my mind that the stock market topped out in May, and periodic short-term rallies notwithstanding, is in a correction in its unfavorable season that will not end until October or November, and that investors should lean toward using the inevitable short-term rallies that take place, to lighten up and take on defensive positioning.

Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.