What is going on with the market? (Part 1)

Over the past few weeks, you have probably seen your investment portfolio move up and down in value. Of course, investing in the markets means dealing with uncertainty, which encompasses both pros and cons. Uncertainty causes volatility, but this volatility allows rational investors to increase their holdings at a cheaper price. So, we will attempt to explain what all the fuss in the market is about:

Impact of Fed decisions

The world equity markets have become more sensitive to recent comments by officials from the Federal Reserve Board (Fed), as well as to the offshoot fears of inflation or an economic slowdown. The whiplash reactions to Fed rumours and innuendos have propelled the markets on a round trip.

Following the US Fed Open Market Committee meeting in March, one more interest rate hike was expected in May followed by a break. However, the picture clouded again as several Fed members seemed concerned about rising inflation and determined to raise rates, while others were more positive and inclined to pause.

In April, when it appeared that the Fed had stopped raising rates, the markets rallied sharply, with the major indices up as much as 5 per cent over several weeks. After the May Fed meeting, when Chairman Bernanke and others expressed a preference for higher rates, the markets sold off just as sharply. The damage was not limited to North America. As central banks in Europe and Asia began to raise rates, emerging and international markets fell after having posted extremely strong gains for the first part of the year. Not surprisingly, when emerging markets dropped, so did commodity and energy stocks (which we have been saying for a while). They pulled back in May with many experiencing double-digit losses.

Currently the main concern is that that the Fed and other central banks could make a mistake and move rates too high. This bid to reduce inflation might stall economic growth around the world, which would affect company profits. Less return means a reduced amount of earnings, thus lowering stock prices.

Rising interest rates and inflation have never been market friendly. However, the threat of inflation often gains momentum during the latter stages of a Fed tightening and economic cycle.

Other factors

Realistically, much of the market volatility is due to the relatively light trading volume marked more by a lack of buyers than a deluge of sellers. This trend occurs most summers as people begin their holidays. Trading volume moves lower so that fewer trades create greater volatility. In short, recent dramatic headlines notwithstanding, the markets were defined more by uncertainty than panic and more by "wait and see" investors than "oh my God" investors. The recent sharp declines in the markets may also indicate that enough bad news is contained in expectations to allow a rally if the numbers are anything but poor. And given the recent decrease in many commodity prices including copper, we would expect inflationary pressures to ease going forward.

How investors react

Today we have access to more information about our investments than ever before. Many investors assume that this information helps them become better informed, so they can make improved investment decisions. However, the opposite often occurs. Looking at investment performance monthly, weekly or even daily can hamper some peoples' ability to make good decisions. It causes them to panic when they should be realistic and focusing on their long-term objectives.

A fall in market prices is inevitable at some point, simply because cycles occur in nature. There is no such thing as an elevator that only goes up, which is what the stock market is doing right now in everyone's mind. People's behaviour changed and prices were raised until stocks became overvalued. This inevitably caused the elevator to come down. Similarly, when the elevator comes down, it then can move back up.

The human emotions associated with peaks and troughs in the market led to inappropriate extrapolation, which means using data from the recent past and projecting it immediately to the future. For example, if the market was down yesterday, an investor tends to be overly pessimistic about markets in the future. Focusing on interim and sometimes-volatile changes can undermine investor confidence, and the investment becomes less appealing.

Article Continues at "What is going on with the market?" (Part 2)