The Only Way To Survive Market Chaos, By Steve Sjuggerud

"People are in a hole and they just keep digging," my dad said on the phone this morning. Leave it to my dad to sum up the message of last week's Investment U E-Letter (#156: Getting Back What's Gone) in one sentence.

I remember when I was last in a real hole. If I'd kept "digging" I would have died. It was my only near-death experience...

I was pinned to the bottom of the ocean under a large sail. I was only in about two feet of water, but waves were breaking over the top of this windsurfing sail, pinning me flat. Even worse, I was connected to the sail by the hook of a seat harness, and in a twist of bad luck, this harness was caught. I couldn't get myself unhooked from the sail to try to swim out from under it.

I started panicking. I was out of breath and out of options. I remembered that someone had drowned in this exact spot, in the exact same way, a few months earlier. Now I'd probably been under the sail for over a minute. As I was scrambling and it was looking pretty bad, something came over me. All of a sudden I told myself to relax...and THINK! There has to be a way out of this...

And there was... Believe it or not, I stopped what I was doing. I (reasonably) calmly assessed the situation. The hook was stuck. I couldn't get it undone. But I COULD undo the ENTIRE seat harness, taking it off my body. It was a few buckles and straps, so it would take a little while, but it was a sure thing. And it worked.

I crawled up the beach and sat. It took a long time to catch my breath. Then I went home and slept. For hours. But at least I'm here to tell about it. And it's all because while I was in a serious hole, I made a lifesaving decision - to stop digging. To stop scrambling. To stop panicking and calmly assess the situation. It was the only way out.

STEP BACK AND ASSESS THE SITUATION

Most investors are in a hole right now. And most will choose to keep digging, which will quite likely ruin them. But the few that can step back - and assess the situation as calmly as possible - will be just fine.

Assessing the current situation in the stock market calmly, we find three things...

1) Stocks are still somewhat expensive by historical standards.
2) Stocks have fallen 40% -- the biggest fall since 1929.
3) Investors are spooked.

From these three things, we can draw a few simple conclusions. Let's take them one-by-one:

1) Since stocks are still expensive, chances are, we won't see extraordinary returns from stocks over the next decade. That doesn't mean returns will be bad, it just means they probably won't be fabulous. How about a little lower than the long-run average return of stocks? That would mean returns in the high single digits.

2) The 40% fall in share prices IS significant. In today's "Wall Street Journal," Jeremy Siegel reminds us of the following:

"There have been six major stock market peaks in the past 100 years. After the market dropped by 40%, subsequent five-year returns have averaged 8.6% per year ABOVE INFLATION and none has been negative. And all subsequent 15-, 20-, and 30-year returns have not only been positive, but have also been above the 7% long-run average real return on stocks."

Now that's the best reason for cheer I've heard in some time. If the "real" return is 8%, and inflation is 2%, then 10% average annual returns in stocks from this point forward are not out of the question at all.

But while what Siegel says may be reason for cheer...I'm still not buying. Assessing the situation calmly, I see that the stock market had become more expensive than it's ever been this time around, by a long shot. Sure...a 40% fall is important. And Siegel's facts are noted. But there are only six historical examples of this. No first-year student of statistics would deem Siegel's research as usable. It's interesting. Something to talk about. But not something to hang your hat on.

3) Now...as for the third point I mentioned earlier - the fact that investors are spooked - that is reason to cheer also, actually.

"THE MARKET IS MOST DANGEROUS WHEN IT LOOKS BEST; IT IS MOST INVITING WHEN IT LOOKS WORST." - Frank J. Williams, a great stock trader of 100 years ago, quoted from Siegel's article today.

There was no fear in the market in March of 2000, when the NASDAQ was at 5,000. Now the market looks terrible, everyone is scared, and the NASDAQ is at 1,200.

Funny how it looks risk free at 5,000, and risky at 1,200.

WHAT WE "KNOW" RIGHT NOW

There is a gauge of fear in the market. It's called the Volatility Index, or the VIX, for short. And when it peaks, stocks rally (often 20% in three months). Believe it or not, the VIX hit levels not seen since September 11th this week. And sure enough, we had a huge rally on Thursday. It could be the start of good things to come, in the short run at least.

So based on these three "knowns," we know this:

-The market is expensive and may not produce extraordinary returns over the long run.
-The market has fallen 40% and the little historical evidence suggests that you might do okay from here on out.
-The high level of fear right now out there may allow the market a quick 20% upward burst in the short term.

Well now...this is a little frustrating. These three indicators are indicating somewhat different things. Weak long run, decent long run, and strong short run. All maybes, mind you. So how should you approach this?

THE APPROACH I'M RECOMMENDING

The approach I'm recommending to readers of my newsletter - "Steve Sjuggerud's True Wealth" - right now is as follows: subtract your age from 100. Then cut that number in half. That's how much you should have in stocks right now.

So if you're 60-years-old, you should have 20% in stocks right now. That's 100 - 60 = 40. Cut 40 in half and you get 20. There you go.

When conditions become more favorable (say, when stocks are cheaper, or the indexes start to turn around), you'll want to return to my basic 100 minus your age rule. When we get back to that point, 60-year-olds could have up to 40% in stocks. But we're definitely not there yet. Stay with me here in these Investment U E-Letters, and I'll let you know when that day comes.

Until then, keep your head screwed on straight. Make sure you cut your losses as always. Adjust your allocations to 100 minus your age divided by two.

And stay cool... You can't control the stock market, so don't lose any more sleep about it. You can't lose sleep over things that are out of your control.

Rise above the chaos. Stick with your plan. Cut your losses so you're never in the position to have a catastrophic loss. And have your first good night's sleep in a while.


Good investing,

Steve

Steve Sjuggerud, has a doctorate in finance and has been regarded as one of the best researchers on the stock market around. He is the editor of "Steve Sjuggerud's True Wealth" and has been a member of the OC Investment Advisory Panel for more than five years and is the co-founder and President of Investment U. Before 1996 he'd been an analyst, a broker, and vice president of a global closed-end fund, in charge of trading. In 2001 Steve ran his own hedge fund.

He will be a featured speaker at IITM's Basic Stock course, December 7-8.

Article reprinted with permission from Investment U. To learn more about them visit their website http://www.investmentuonline.com/ #157 The Only Way to Survive Market Chaos, The Investment U E-Letter from July 25, 2002