Short term market movements are often the result of what I call “guilt by association” trading. Along with the dramatic decline in sub-prime mortgage lending stocks, there has been a huge drag on most financial services companies, even if there is little, if any, evidence that the meltdown in sub-prime is set to spill over into other areas.
One of the main reasons the market has been weak lately is because of the underperformance in the financial services sector, which is the largest segment of the S&P 500 index. While mortgage lenders should be tanking ( given that they lent money to people who could only afford the temporarily low monthly payments for their new homes, and not the higher payments that would take effect when the variable rate mortgages adjusted), should every consumer finance company be getting thrown out with the bath water?
Surely there will be some spillover, as there are always lenders with bad standard practices, but we’ve seen everything from credit card companies, to auto lenders, to bad debt collectors, to student loan companies (just to name a few) all get crushed in this environment. Unless you believe that every type of consumer lender had loose credit standards on par with the sub-prime mortgage lenders, there are opportunities everywhere to snap up cheap stocks. Wall Street is acting as if sub-prime loans are the majority of the loans out there, not a small minority. Investors can take advantage of that, and should.
There is an old saying that “the market can remain irrational far longer than you can remain solvent.” This is very true, and just because many financial stocks are trading at what I would consider unwarranted levels, it doesn’t mean they can’t go down further. You may even reach a point, like I did this week on one of my holdings, where the pain is so great (not really because of the drop in the stock price, but more because of the irrationality of the drop along with its magnitude) that you just throw in the towel like others are doing.
You know that doing so could very well mark the bottom and prove to be a horrible trading decision longer term, but in the short term it will help you psychologically to just not have to see the irrationality continue. Patience is the key for value investors, but sometimes it’s just too hard to be as patient as the market requires you to be. That is why the stock market is as much a psychological exercise as it is a quantitative one.
If you have some financial stocks, either in your portfolio, or on your watch list, that are getting unfairly punished recently, do your research and make sure the worries are relevant before selling the positions. If you can hold on (and even buy more) and not have it be a psychological drag on your trading mentality, you will likely be rewarded when all the dust settles, the truth comes out, and many of the current speculation is proved wrong.