U.S. stock market indexes declined yesterday by more than 3% in reaction to Italy’s financial troubles. Specific concerns are that Prime Minister Silvio Berlusconi’s resignation will not be enough to bolster confidence in the economy. The government’s borrowing rate rose to 7.2%, which will increase their deficit, which in turn fuels concern that they might need a bailout to avoid a default on their debt.
The concern about Italy comes just on the heels of the apparent resolution of the Greek debt crisis. Several weeks ago we wrote that while concern about the potential default of Greek debt was certainly justified, the daily price movements seemed to be an overreaction compared to the news content. While the Italian situation is certainly different than Greece – the Italian economy is much stronger and the likelihood of a default is lower, although the impact on the world economy if it did default is significantly greater – we will likely once again see sharp daily movements in stock indexes in reaction to even minor news events coming out of Europe over the next few weeks.
Our recommendation is to remain consistent in your investing strategy. While markets may appear to seem risky, a far riskier strategy is to move in and out of the stocks based on recent price movements. Indeed, even after yesterday’s decline, the S&P 500 is still 7% higher than it was when we published our commentary on Greece in late September. Price-earnings ratios around the world are still well-below historical averages, which means earnings and dividend yields are relatively high. While we can never be sure of what the future brings, we know that selling after a downturn locks in a loss, and misses the upside return potential when the market rebounds.