How to make sense of the stock market's wild ride | Money …

How to make sense of the stock market's wild ride | Money …

“Keep
calm and carry on.”

Brad
McMillan, chief investment officer at Commonwealth Financial, keeps a copy of the
famous motivational World War II-era British sign above his desk but insists he
didn’t need to refer to it once during what felt to many observers like a stock
market meltdown throughout
the day Thursday
.

McMillan,
however, was far from hitting the panic button.

“I’ve
seen things bounce up and bounce down before like this, and I had already
established at what points I’d start to get worried about stocks,” he says. Last week’s blurp doesn’t even set his yellow “caution” light flashing. (For
the record: that would only start when the S&P closes below 1,828, and he’d
only really worry if it fell beneath 1,760.)

That
doesn’t mean that the rest of us don’t feel as if we’ve embarked – under duress – on the latest rollercoaster. The Bull Market Momentum Terror
Ride is exhilarating whenever we set new highs, but what we fail to recognize is
that the steeper the climb, the bigger the inevitable plunge. And while we’re
in the midst of one of those dives, it’s all that we can do to contain our
fear. We can’t think ahead rationally, to understand that virtually all of
those precipitous declines are followed by more upward climbs of some kind.

That
said, Thursday’s 2.1% drop in the S&P 500 wasn’t just the largest one-day
decline in the bellwether stock market index that we’ve witnessed since
February. It is taking place at a particularly tricky point in time.

Momentum
felt great when it was working in our favor
. It
has been only little more than a week since the S&P 500 last set a new
high. And the index has kept on hitting records throughout the dreary winter
and spring, in spite of the fact that the weather has put a damper on economic
activity, hurting everything from homebuilding to retail sales.

But
those gains have catapulted us into uncharted territory and left us squabbling
over the point at which the stock market goes from being nicely valued to just plain overvalued. (Unhelpfully, there are as many answers to that question as there
are pundits eager for their five minutes of fame on CNBC.)

What is certain is
that we’re paying a far
higher price for every dollar of corporate earnings
than we were a year ago.

That’s
particularly true since we’re right smack dab at the start of earnings season.
In early January, when the first quarter kicked off, analysts gleefully predicted
that S&P 500 companies would report earnings growth of 6.6%. Today, they’re
expecting something closer to 1%
.

Earnings
season will drag on until mid-May, meaning that there is plenty of potential for
other disappointing results to damage confidence in the stock market.

And
yet … By far the worst of last week’s selling pressure – the real market
meltdown – was confined to a handful of corners of the Nasdaq Stock Market.
While the S&P 500 was down 2% on Thursday, the Nasdaq had plunged 5.6%,
posting its worst
drop in more than three years
.

“There
are pockets here that had seen silly inflation in stock prices,” says
Commonwealth’s McMillan. “Now they’re sending out signals that they’re starting
to behave rationally.”

On
the margins, this had already happened. King Digital’s “Candy Crush Saga” game
may have turned Facebook users into addicts, but the company couldn’t
demonstrate to the satisfaction of potential IPO investors that it was more
than a one-hit wonder. When desperate bankers finally
managed to complete the deal
last month, the fledgling stock promptly did a
face-plant.

Veterans
of bubble-prone sectors like biotechnology already were wary. Even as mutual
fund manager Tom O’Halloran was picking up awards and kudos early this year
(his Lord Abbett Micro Cap Fund earned 74% for investors in 2013, thanks to big
gains from tiny biotech companies), he was already selling some of those
holdings.

“There’s a lot of irrational exuberance in this space, and a lot of
excessive outperformance,” he told me on April Fool’s Day.

A
case in point? Intercept Pharmaceuticals, a speculative company with 45 employees and no products on the market in which O’Halloran had taken a small
stake. When the company announced a clinical trial had been halted early
because results were so promising, the
stock nearly quadrupled
– in a single day.

That’s great news, but O’Halloran
figured the market reaction was over the top. “We were paid in two days what we
thought – absolute best case – we thought we would earn in two years,” he says.

Stocks like that in the biotech arena, one of the worst hit by Thursday’s
selloff, are the reason O’Halloran was already scouring the stable and
cyclical growth markets in search of alternatives.

Waves
of big selloffs like those we’ve witnessed in recent days
tend to happen when people have been counting on their speculative market bets to pay off in big profits – only to be disappointed.

Unless
you’re a speculator, too, little of the market drama
should cause you much anxiety. Hopefully, your portfolio isn’t overloaded with
high-flying stocks that are now bearing the brunt of the selloff, so unless
you panic and sell, for now, at least, your losses are only on paper.

Should
you sell? Well, there aren’t any signs that what we’re seeing now is fueled by
anything more than typical valuation jitters and the kind of jolt you get when the market comes down to earth. (It’s kind of the same feeling that you get when
you’ve been running and slip on a patch of ice and end up hitting the ground with
a thump.) And the very fact that the market can take fright so readily is, perversely,
reassuring: it shows that someone, at least, is paying attention.

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How to make sense of the stock market's wild ride | Money …

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