Stocks Down 12% in 9 Days - Here's Why

Last Updated Aug 4, 2011 4:42 PM EDT

Note: This is an update of a previous story - Stocks Down 7% in 7 Days.
Stocks closed down five percent today alone. U.S. stocks have now declined eight of the last nine trading days, losing over $1.8 trillion. Stocks declined in May, June, and July. So far August worse than the three previous months combined. Let's look at the media's explanation and give it a smell test. Then I'll frame it differently for an explanation far more likely to be valid and actually make you some money.

Media madness
The world remained fixated on the August 2nd grease fire that was the potential US default. I was as well. As the date drew nearer, the market declined, losing 4.1percent alone last week, while Congress doubled-down on the partisanship and seemed hopelessly deadlocked. The media attributed the stock decline to the possible default.

Suddenly, over the weekend, a compromise was struck to avoid the default. Instead of stocks surging, they declined faster. The media, which has an explanation for everything, offered three reasons for the further decline, which were:

  1. Manufacturing numbers were disappointing.
  2. Personal spending was down.
  3. The size of the bill passed was too small.
I'm not buying it. How about we run those theories up a flag pole and see if anybody other than the media salutes them? Let's give it a reality check. For the first half of this year, the news was grim. Though an improving economy was expected, the results were disappointing. Our global economy faced potential defaults in Greece and Portugal, and witnessed the natural disaster of a Tsunami in Japan as well as the man made disaster of a nuclear meltdown, greatly impacting its economy. Yet the US stock market responded by increasing by 5.9 percent in the first six months.

The impact of a US default could have been catastrophic. The relief from avoiding it far outweighs disappointing manufacturing and spending numbers. Thus, I'm not buying the media's explanation.

The real reason
To examine why the market declined, we need to frame the situation differently and over longer periods of time. Let's step back a few years.

On October 9, 2007, irrational exuberance ruled as the market hit an all time high. The tide of reality rushed in swiftly during 2008 and early 2009. Then came the great stock market recovery. By the end of April this year, US stocks were within 2 percent of the 2007 stock market high, as measured by the total return of the Wilshire 5000.

I was quite nervous that stocks were back to where they were when the paradigm that real estate could never decline ruled, or when Lehman Brothers and AIG were viewed as brilliant conservative institutions. I wrote about 5 reasons stocks may be overvalued.

So in the context of stocks being down 13 percent since April 30, maybe it has little to do with the Congress bickering or economic numbers being disappointing. Perhaps it has more to do with a pull back from the 119 percent surge since the 2009 market bottom.

My advice
I'll fess up that I'm using hindsight and my explanation may not be the real reason either. The stock market is a complex organism that we all want to understand. Unfortunately, believing we understand it, let alone that we can predict it, is a costly delusion.

I have reduced my equity positions a bit this year to rebalance. I suspect I sold my equities to the same people I bought them from after the plunge, when stocks were on sale and no one was buying. If they plunge again, I'll gladly buy them back. I love "Hurt's So Good" investing!

A comment was made on my previous piece on "Stocks losing 7 percent in 7 days" predicting that the coming plunge will make 1929 and 2008 look like a minor correction. Oddly enough, this comment was rather comforting because the last time I heard this sort of pessimism, markets more than doubled.

So try to ignore the media and market gurus. Like the rest of us, they're merely grasping for any news that might possibly explain why the market did what it did that day.

More on MoneyWatch
5 Reasons Stocks are Overvalued
Stocks on Sale - Why are so Few Buying?
7 Habits of Highly Effective Stock Gurus
Hurts So Good Investing
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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.