The market can be finicky over the short term.
This has particularly been the case over the past few days, with stock prices fluctuating widely. Some stocks have been excessively volatile. Take Mastercard for instance, shares fell 10.6 percent on Monday, rebounded 10.6 percent on Tuesday and fell 5.9 percent on Wednesday. The stock gained 7.7 percent yesterday. One does not have to be an expert on Mastercard to assume that its business does not change that much on a daily, or even weekly, basis.
In his classic book, "The Intelligent Investor," Benjamin Graham described Mr. Market as a business partner who "lets his enthusiasm or his fears run away with him." The description certainly applies to the erratic price movements we are currently seeing. Over short periods of time, the markets do not act in a rational manner.
This is not to say that everything is fine or to ignore some of the recent headlines. Economic growth has been slower than economists expected and could remain sluggish for the foreseeable future. The risks of a recession have increased. Standard & Poor's downgraded the United States' credit rating. People are worried about the economy, the stock market and now, French banks.
Yet most of this is not surprising. There have been several economic reports that pointed to sluggish growth. The U.S. debt exceeds $14 trillion, and our elected officials in Washington have yet to agree on a long-term solution, whether it is based on Simpson-Bowles or an alternative. Predictions of when the Federal Reservewill raise interest rates have proved to be premature, as Tuesday's Fed statement made even clearer.
If the markets were truly efficient over the short term, prices would reflect not only these facts, but also the realities that the U.S. economy is still growing and large-cap stocks are cheap relative to trailing and forecast four-quarter earnings.
Rather, we are seeing volatile conditions caused by a combination of headline risk, investor emotion and rapid-fire electronic trading systems. It's not fun, but this volatility is why stocks deliver high long-tem returns.
The annualized 9.9 percent long-term gain for large-cap stocks is Mr. Market's way of saying "I'm sorry for driving you crazy."
So what do you do with Mr. Market? The temptation is to love him when stock prices are rising and leave him when stock prices are falling. The problem is that his mood can change quickly and he rarely announces that he has gone from being glum to chipper. So, you have to either correctly guess what his mood will be from day to day (a very difficult task) or invest for the long term and ride out his temper tantrums.
Either way, you should use down markets to look for bargains. Fear, as uncomfortable as it is, causes stocks to be mispriced. Even if you think stock prices can fall further, you should at least create a list of stocks that either look attractive or would be attractive if their prices fell further.
I have yet to see a correction where people didn't fear a catastrophe, or a rebound where people didn't wish they had bought during the correction. I don't think this time will be any different.
Charles Rotblut, CFA is a Vice President with the and editor of the AAII Journal.