The Insanity of the Market's Reaction to the Fed This Past Week

Investors' reaction this week to Ben Bernanke's comments about the future of the Federal Reserve's stimulus programs were nothing less than insane. Well, perhaps "insane" isn't quite right. The market has looked more like a toddler throwing a tantrum when a grown-up told him he can't have his way all the time.

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) lost 1.79%, or 270 points, this past week. On both Monday and Tuesday of last week, the Dow rose by more than 100 points each day. But on Wednesday and Thursday combined, the blue-chip index fell more than 550 points, after the Fed chairman told investors that the central bank sees signs of a strengthening economy, and as that long as the economy continues down its current path, the central bank will soon begin slowing its stimulus programs. Cue the tantrum. The markets experienced their worst week in nearly two months.

Even though the Dow rose by more than 200 points during the beginning of the week, the past five trading sessions added up to the worst week since April 15-19, when the Dow lost 317 points, or 2.1%. But one big difference between this week and that one is that in April, the Dow had only 19 losers at the end of the week. This past week, 27 of the Dow's 30 components saw their prices decline.

Furthermore, back in April, the Dow's worst performer was IBM (NYSE: IBM  ) which lost 10.11%. The reason that matters is that the Dow is a price-weighted index, which means that stocks with higher prices have a larger impact on the index. Since IBM represents 10% of the Dow's total score, when it lost 10% in April, it singlehandedly cut around 160 points from the index, or around half of its loss that week. 

This past week, in contrast, IBM lost 3.74%. That's still a large decline, but it represents only about 57 points of the Dow's 270-point loss. This time around, AT&T (NYSE: T  ) was the index's largest decliner, losing 4.47% this past week, but the stock represents only about 1.4% of the Dow, so it didn't play a major role in tanking the index. The next largest decliner, at 4.13%, was Travelers (NYSE: TRV  ) -- which, besides AT&T, was the only other component to lose more than 4% of its value. But, while Travelers' weight is substantially larger than AT&T, it still makes up only 4.1% of the index, ranking it as the 10th heaviest component.

The point is that this past week's drop was a broad market descent, meaning that stocks in general across the board declined in value, based on news at a macro level. As the old Warren Buffett saying goes, "Be fearful when others are greedy, and greedy when other are fearful." This is one of those times we should be getting greedy.

Bernanke's view that the U.S. economy is growing stronger should signal to investors that corporate revenues and profits should be rising in the future. If we believe that the long-term price of a stock is based on profits, then we should be buying stocks today, with the belief that we'll see higher profits in the future. In addition, when we see big market moves caused by macro events and not company-specific news, value investors should start salivating. The market is essentially selling shares of quality companies at a discount for no logical reason.

So why would stocks fall in reaction to Bernanke's comments? One view is that investors believe that when the Fed shuts down the free-money spigot, the economic growth we've seen over the past few years will come to a halt and we'll experience a period of extremely low GDP growth -- an environment in which corporate profits would struggle. The problem with this theory is that the Fed has told investors that if economic growth begins slowing after it ramps down its stimulus, it will come back in to give the economy another kick-start. That tells me the Fed will essentially backstop the market at a level it thinks is appropriate.

Final takeaway
If the markets fall even when the Fed talks merely about slowing its stimulus, and if the theory about a slow economy in the future plays out, we'll probably see a few more big drops from the market in the coming months. But if the markets continue to fluctuate, it should give long-term value investors some great buying opportunities in the future. Furthermore, if we practice the principle of buying in thirds, we should be able to fully build a position in the coming six to 12 months, during days or weeks when the market is falling because of macro events such as we experienced this past week.

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Comments from our Foolish Readers

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  • Report this Comment On June 22, 2013, at 3:39 PM, johnsleake wrote:

    Your reasoning seems very sound, but I am concerned that major market players do not consider QE as a means to and end--i.e., stimulating economic growth--but as a desirable end in itself. I get the impression that QE has somehow provided major market players with extra funds to deploy in the stock market. Perhaps those who are selling Treasury bonds to the Fed are using the funds to bid up stocks. Once these funds are withdrawn, there will simply be fewer dollars chasing the same amount of shares. Frankly, I'm not sure if this is true, as I have yet to find a comprehensive account of the precise mechanics of QE. At any rate, it seems like QE is the object of desire, and not its possibly salutary effects on the economy. It's tempting to suspect that there is something fishy about the entire enterprise, just as there was something fishy about all of those phony Dotcome issues in the late nineties, and something equally fishy about mortgage backed securities and the ratings agencies in the early to mid 2000s. Given that Wall Street is an ethics-free zone, I wouldn't be surprised if QE proves itself to be another corrupt game.

  • Report this Comment On June 22, 2013, at 3:41 PM, JeffB2013 wrote:

    The real insanity was the DJI rising 3000 points in less than 6 months, mostly based on the easy money policies of the Fed. Policies which, by the way, are not achieving the stated goals.

  • Report this Comment On June 22, 2013, at 4:22 PM, Blknblue wrote:

    The market reacted properly. There is not one single thing outside the new money injection by the Fed to warrant the growth of the market. The media reports even a tenth of a point gain in anything as positive. The old idea the market was a reflection of the economy went out the window with Tarp and the Fed's manipulation.

  • Report this Comment On June 22, 2013, at 4:36 PM, 1kirkwood wrote:

    I would be selling bonds right now. If there is one thing ridiculous, it is the overly low interest rates. Thirty year bonds from the Treasury should be inflation (2%) plus 3 points for return or at least 5% not 3.5%. So watch out if you hold bonds. Stocks should go up if the economy continues recovering.

  • Report this Comment On June 22, 2013, at 4:38 PM, Fooloprunes wrote:

    I don't think "insane" is too strong a word. The market is highly irrational because too many players (including a lot of major investment houses) are looking to make a fast buck using instinct rather than an assimilation of real data.

  • Report this Comment On June 22, 2013, at 4:54 PM, cwnuechter wrote:

    Insanity is the printing of fluff money into the economy at the rate of $85 b per month to keep the lid on a deplorable economic situation. Some will write books on this catastrophy years from now. Do people really understand that all this printed money is debt with only one exit which is the US taxpayers $. Sad!!

  • Report this Comment On June 22, 2013, at 8:44 PM, Seanickson wrote:

    Interest rates (and expectations) always have and always will affect valuations. Like gravity as Buffett has said. There are also some concerns that increased interest rates will increase money velocity and ultimately lead to inflation which is very destructive to equity returns.

  • Report this Comment On June 22, 2013, at 11:52 PM, pawoodtick wrote:

    For months, the media hype has been that the market was going to correct. And it kept on going forward. Yet, the media gurus kept on telling us that the summer doldrums are upon us, and that markets were bound to fall, as they always do.

    Now, they've fallen and of course, its all the investors fault for listening to the gurus. They've been spooked by the massive outpouring of lectures on how the markets are overpriced, summer slumps and how much QE infinity has to do with overpriced markets.

    This isn't a market crash. This is merely a pullback off the highs. Its called a correction and its a normal market fluctuation. Those that have jumped out because the Fed is going to change their policy next year may have drug the market down a bit, but in the long run, they'll be on the outs because the market will surge higher as money from the failed Euro pours into the market with no better place to go.

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