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What to Do When Stocks Fall

By Dan Ferris, editor, Extreme Value
Saturday, August 11, 2007

The current stock market situation reminds me of the 1999 Tom Cruise movie Magnolia.

At one point in the film, the sky opens up and starts pouring rain. But it wasn't just raindrops falling. It was also frogs. Yes, frogs. Slimy, croaking frogs. Frogs fell from the sky and splattered all over sidewalks and roads, causing traffic accidents and mayhem.

There's a moment in the film, when a young boy is reading about "frogfalls" in a book, even as his house is pelted with momentum-charged amphibians. He looks skyward, smiles, and says quietly, "This is something that happens."

And it is. Frogfalls and fishfalls, as they're called, are extremely rare events, but they are relatively well documented. In 1995, a woman driving through a rainstorm in Scotland reported hundreds of frogs falling from the sky, pelting her car. Another frogfall was reported in Greece in May 1981. Dozens of similar events have been reported all over the United States.

Though they're meteorological mysteries, some believe waterspouts cause frogfalls and fishfalls. Whirlwinds pick up shallow bodies of water full of fish and/or frogs, carry them skyward, and drop them miles away. Whatever the cause, and however rare it may be, it happens. It doesn't mean the sky is falling. It doesn't mean God is visiting a plague upon the earth. It doesn't mean anything, except that it's possible for frogs to fall from the sky.

One would think that, were there an event far less mysterious than frogs falling from the sky, those watching the event might shrug it off and think, "Big deal, it's no frogfall." For example, I've heard it bandied about that the overall market rises perhaps two-thirds of the time. So, it's falling or going sideways the other third. Not exactly an amphibian deluge.

And lately, frogs, er, stocks have been falling. The S&P 500 fell 8% from July 19 to August 5 – just 11 trading days.

Times like the past few weeks underscore the sheer insanity of exposing oneself to fluctuations in market prices for a short period of time. If you're buying stocks, you should only be buying them as long-term holdings. Otherwise, you'll feel like frogs are falling from the sky every time one of your stocks falls 25% or so.

On the subject of how to feel about market price quotations for your long-term holdings, I defer to Ben Graham, who said it better than anyone. "The market is a voting machine in the short term and a weighing machine in the long term."

Today, ask yourself a few questions about each one of your long-term holdings... to see if its weight is worth your capital:

1. Is this a great business, with a sustainable moat and a competitive advantage?

I think we can say this about our Extreme Value holding Microsoft. The software giant makes so much money it literally doesn't know what to do with it. Every new computer will have a copy of Vista on it from here on out, and Microsoft will get a few hundred bucks from each copy.

2. Does it have a strong balance sheet with plenty of liquid assets?

Last month's Extreme Value recommendation has about one-third of its market cap in cash and no debt. Last August, I found a stock that had a big competitive advantage and 27.5% of its market cap in cash. It's up 46% since then.

If the answer to both of these questions is "yes," then you've got nothing to worry about when stocks – and frogs – fall from time to time.

Good investing,

Dan Ferris





Market Notes


GOLDILOCKS IS DEAD

In May 2006, one of our favorite gauges of investor fear, the Chicago Board Options Exchange Volatility Index (the "VIX") broke through a sleepy downtrend as stocks and commodities plunged.

Back then, we speculated the "Goldilocks" market we've seen since March 2003 - where nearly any asset you could imagine soared (Hong Kong real estate... oil... platinum... tech stocks... wheat futures... Picassos... Indiana farmland... you name it) – was over.

Well, Goldilocks came right back to life after that correction, and the VIX eventually sunk to all-time lows near 10, displaying a near total lack of fear in the market place. Now... given the damage done in the past few weeks, the health of Goldilocks is in serious question.

We'll leave the general market predictions to others... but as you can see from this week's chart, volatility is back. Fear levels are at their highest readings since the invasion of Iraq. The VIX has not only broken its long downtrend, it has destroyed it.

-Brian Hunt


Stat of the week



$3,814

How much more Japanese automakers profit per car than the "Big Three."


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