From the May 2007 issue of Wealth Manager Web • Subscribe!

The Dow Blues

On February 27, the DJIA suffered a 416-point loss--the seventh largest point drop in history. Nerves frayed, and markets around the world sold off. Was this occurrence a non-event or a harbinger of things to come?

It was just so much "investment noise," part and parcel of normal market volatility, according to Neil Elmouchi, CLU, ChFC, and founder and president of Summit Financial Consultants, Inc. outside of Los Angeles. The 3.3 percent drop was small in percentage terms, he notes, and he's not doing anything differently as a result.

If you're talking about a one-day event, Drew Tignanelli, CPA, CFP, might agree. Tignanelli is a principal and portfolio manager at The Financial Consulate, Inc., an RIA near Baltimore. "Even though it's scary, markets have done this throughout history," he says. Fear grips the market and investors run for cover, but "one day does not a market make," in Tignanelli's book.

However, there is more to the story than a one-day blip, Tignanelli argues. "The markets are becoming riskier," he says. Big money can move in and out of the market very fast now, not only by virtue of electronic trading, but because hedge funds have bulked up to massive size on debt, then leveraged again by putting borrowed funds into margin accounts. Consequently, "You're going to continue to see these kinds of wild moves more and more," he says.

And it ain't over yet, Tignanelli continues. He wrote an article in late 2006 predicting that we would see the largest one-day point drop in market history this year--and February 27 wasn't it, he says. His argument: It's the first time since 1982 that we have not hit a new high within two years of the start of a bear market. It took seven years to reach a new high this time (after the crash of 2000), and the market quickly retreated. "My feeling is that we're in a secular bear market and [they] don't just end overnight," he says, citing the experience of the 1930s and 70s. The odds favor continuation of the bear market, not a breakout to a new high anytime soon, he says, especially given the fact that the new high in the Dow has not been confirmed by the Nasdaq or the S&P 500. In other words, he believes we are still working out the bubble of the late 1990s.

Not so, says Keith Pinsoneault, CFA, president of Optimum Investment Advisors LLC (headquartered in Chicago) and co-portfolio manager of the new Aston/Optimum Large Cap Opportunity Fund. The 416-point drop was "more a technical trading phenomenon than a reflection of anything changing in the fundamentals," Pinsoneault says. Keep your eye on the ball, he advises, and look at the fundamentals: Economic growth is intact globally, and good in the U.S.--aside from autos and housing. "The rest of the economy is doing extremely well; liquidity is very strong not only here in the U.S., but around the world. There's a very, very slim chance in our opinion that we're moving into a recession," he says.

Moreover, unlike 2000, price-earnings multiples are at the low end of their range relative to the historical average and bond yields. "It's hard to begin a bear market when it's selling at pretty reasonable valuation levels," he maintains.

Whatever your theory, it was obvious that the 416-point drop was preceded by a 9 percent one-day decline in the Chinese market. "China clearly is taking the economic lead in the world. When China hiccups, the world is going to feel it more and more," Tignanelli says. Although some of the commentary in the press has run to the effect that these events show international diversification is now worthless, spreading risk across different countries remains critical: "Just because world markets move in sync at one time doesn't mean they will stay in sync for the entire 12 months ahead," Tignanelli adds.

As Elmouchi puts it, "Non-correlated does not mean negatively correlated." World markets will still move in tandem a good deal of the time, and what happens in one will affect others. Elmouchi did not change international allocations in client portfolios after February 27, he says.

Back in the U.S., says Pinsoneault, the 416-point drop caused investors to reassess the risks emanating from the housing downturn and the subprime mortgage market. U.S. investors had become lackadaisical about risk, as reflected in narrow bond spreads, low risk premia, and stock prices that did not fully reflect the possibility that things could go wrong, he continues.

That much is undeniable, but don't expect appetite for risk to remain depressed for long. The prospect of outsized returns always lures risk takers back. "There are too many people out there who have short-term memories," Elmouchi says. "The market just forgets, and it forgets fast."

Christopher M. Wright (www.sinewaveinvestor.com) is a freelance writer and author of an investment newsletter in Arlington, Va.

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