Nearly all of the analyses of the recent movements of the U.S. and world equity markets are focused on the European economy, and nearly all of the analyses of Europe are based on the troubling Greek financial crisis. The common reason given for last week’s 6% decline in world markets was an increase in the likelihood that Greece will default on its debt. A decrease in that likelihood is the reason given for this week’s 3.5% rebound.
One of my favorite observations in the book Freakonomics is that although shark attacks are constant from year to year, and the risk of going in the water is relatively stable, the fear among the public of going in the water changes as a result of the press reporting about shark attacks. Substitute the words “economic events” for “shark attacks,” and think of the stock market as being the water, and the same observation is true for investing. Short-term volatility is often not a result of the true risk in the market, but instead is a result of the press reporting on events in the market, which in turn is often affected by recent stock market volatility – that is one reason why volatility breeds further volatility. But let’s take a step back and see what this short-term volatility has to do with long-term stock values.
The overall valuation of the world stock market is about $50 trillion. A 6% drop means a decline in wealth of $3 trillion. The overall GDP of Greece is $0.3 trillion and the total value of its debt is $0.5 trillion. So a mere reassessment of the likelihood of Greek default caused a short-term wealth movement equal to ten times its entire GDP and six times is total debt. I have no doubt that there is tremendous concern on the part of Greek citizens and their government on their economic woes, and that a Greek default would affect world stock prices. But the magnitude of impact of the daily news on stock markets is completely out of whack with the economic implications of the news.
Some might say that this is too simplistic of an analysis – it ignores a domino effect that a Greek default would have on other countries (such as Ireland and Spain) and European banks. Indeed, much of the stock market decline in 2008 was blamed on the snowballing effects that the Lehman Brothers default might have on the rest of the economy, which is why the Dow was in the 6,000 range in early 2009. But the evidence over the past three years suggests that those potential snowballing effects were grossly overstated; in part, because of the actions of the government and private sector to mitigate them, just as governments and banks in Europe are working to mitigate the effects of the Greek economy. And that is why the Dow is now in the 11,000 range.
Our advice is to stay in the market. The real shark out there in the water – the one that causes true risk to your portfolio – is the one that occurs when you move in and out of the market solely because of market movements and press headlines.