Here are the numbers for this week:

  • Dow Industrials – down 4.2%
  • S&P 500 down 4.9%
  • Russell 2000 down 7%, now in the red for the year
  • REITs down 8.8%

The two day rout on Thursday and Friday were quite dramatic, but the declines are still in single-digits across the broad indexes. The panic and consternation are certainly overdone. Several headlines and commentary are acting like we just went through a full bear market, claiming that “stocks are so cheap now” or “where was the plunge protection team — surely we needed it this week!” I’m sorry, but if a 5% price dip makes a stock “cheap”, you don’t understand what the word cheap means and you have no sense of scale.

I’m not going to join the cheerleaders who say “this kind of thing is a healthy correction” or any similar blather, but I would want to put the 5% drop in perspective. Only the Russel 2000 is negative for the year, and by only 2% in that case. Unless you started investing a few months ago, you’re likely still up for the year. My own portfolio has certainly been punished, but not out of proportion to the high volatility that one should expect in the equity markets.

There is plenty of concern for whether this marks the beginning of a new bear market or not, and that is more valid question than the concerns over the percentage losses this week.

There are two likely scenarios from here. Either Monday we’ll continue to slide downward at a scary pace, or there will be a sharp rally. The best thing to do now is to figure out what you want to do in either situation. Make the decisions now rather than when emotions are in full swing, and the Dow is dropping another 500 points in 2 days…

If a trader has enough conviction that a bounce is going to happen (or vice versa) they could start positioning themselves now in anticipation of quick moves… but they would also remember to cut their trades short if the market does not agree with their beliefs.

If you’re dollar cost averaging, then there’s no impact to your plans. If you re-allocate assets at discretionary points in time, you might want to determine what market activity over the next few weeks would motivate you to rebalance, and whether to rebalanace towards or away from risk.

If you’re an active investor, the best phrase I can think of is “if you’re going to panic, panic early.” Know at what point you are going to get out of the market if it continues to fall, and stick to that point. There is opportunity cost if the markets don’t continue falling; but if you hold on during a downturn despite your own exit strategy, your losses are real.

I personally am monitoring my stop losses on my positions. I’ve stopped out of several stocks as they have fallen more quickly than the indexes, and have built my cash reserves. On the flip side, I’ve also put on a few new small positions that could benefit from a bounce or continued weakness.

What should we watch going forward to get clues for which way the market will go?

Breadth has been poor, and my understanding is that it leads the market. You can watch the NYSE AD (Advance/Decline), or similar indicators on this page under the section “market breadth”.

One theory is that hedge funds were piling into the most liquid stocks in the last month or so, with the theory that if the market turned they would have enough liquidity to get out and not get frozen without a bid like in the credit markets or small caps. This lead to higher highs in the cap-weighted indexes, but left the majority of the market behind. This leads to this week’s dramatic drop, and the phrase “in a crunch you sell what you can, not what you should.”

The Yen is tied at the hip to the stock market, we haven’t seen a real drop in the indexes without the Yen rallying at the same time. We should watch for any divergence between the markets and the Yen.

One odd scenario is that we could see dollar strength as US investors bail out of over-heightened emerging markets and global stocks, or some carry trades get reigned in. Keep an eye on the USD, EEM (emerging equities), and EMD (emerging debt) to see if this starts to play out…

Bond rates should also be monitored… If the 5/30 year treasury spread confirms the upward trend and doesn’t stay in a range, we will see more credit and liquidity contraction, which should be bearish for the markets.