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What to Make of the Market's Latest Swoon

Morningstar's Christine Benz and Jeremy Glaser explore the recent stock market weakness and what investors should do about it.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Markets are off again today after a big sell-off last week. I am here today with Christine Benz. She is the director of personal finance. We are going to take a look at what might be causing this sell off and what investors can do about it. Christine, thanks for joining me.

Christine Benz: Nice to be here, Jeremy.

Glaser: So, one of the big pieces of news, or the elephant in the room in a lot of ways, is Standard & Poor's downgrade of United States sovereign debt away from that AAA level. Do you think that's really what's driving these market movements?

Benz: I don't, I think a lot of us this weekend were kind of on pins and needles, waiting to see what would happen as a result of S&P downgrade. The most direct thing you can look at to see whether the market cares is Treasuries, and Treasury bond yields have actually been going down and prices have been going up. So, investors don't seem too concerned about the downgrade. As you and I were talked, Jeremy, it's not like any of the news that S&P conveyed in its report really was news to the market. So yes, we're at a political impasse in this country. But big surprise there? I don't think so.

Glaser: Yeah. I think certainly it doesn't seem like anything in that S&P report would have been terribly shocking to anyone who has followed, even just tangentially, some of the stuff that's going on in Washington, such as how there hasn't been an agreement about revenues and about how much should be cut. But at the same time, the other rating agencies have affirmed the AAA rating; they thought the deal went far enough. And it seems that investors still really see Treasuries as a safe heaven. I think in terms of liquidity, you're not going to get any other securities that just have the kind of depth that you get in Treasuries; we haven't seen a big sell off there. I think we can talk in maybe 20 or 30 years from now, and I think we will probably see this as a historic political moment.

Benz: Right.

Glaser: I think it's something we're going to be hearing a lot about ahead of the 2012 election, but certainly in the short term, there hasn't been a lot of financial dislocation?

Benz: No, there hasn't. It does appear, as you said, that either political faction could find something to seize upon in the S&P report. So I do think that, yes, it will have political spillover effects, but at least in the near term there don't appear to be big market effects.

Glaser: So, if the downgrade maybe isn't the driver here. What are people concerned about? Why are we seeing just all of this red ink?

Benz: Well, I think Europe's woes continue unabated. People are very concerned about the ramifications of what's been going on in Italy, which is obviously a far bigger fish than the other economies that have run into trouble so far. So I think that's part of it. More broadly, Jeremy, I think that people are concerned about growth, not just in Europe, but here in the U.S. And so, last week we had that steady dip-drop of bad news regarding the economy, and I think that that's the big concern. So, you've got stocks that maybe are fairly valued or maybe they're undervalued, but it really depends on that growth and on that earnings part of P/E. And if you are optimistic about growth, maybe it's a buying opportunity now. But if you are concerned about growth, as many market participants seem to be right now, the P/E on the markets that we had a week ago just wasn't justified.

Glaser: Yeah. I certainly think that we're going to be hearing a lot about Europe. We thought that maybe we could stop hearing so much about the sovereign debt crisis. I think that we're only going to be hearing more. It seems like the European Central Bank and the European Union keep coming up with new plans, new bond-buying schemes, new ways of bailouts, and new ways of restructuring the debt. But the truth is that they are probably going to see more defaults, more restructurings in some of the peripheral countries and that the growth just isn't going to be there to grow their way out of the problem; they going to have to find new solutions.

So, turning to investors' portfolios, you see all of these falling stocks, and your portfolio returns are looking pretty dreadful as they are probably going to this quarter. So what you do? What should investors think about, what should be on their minds?

Benz: Well, you often hear people counsel against panic-selling at a time like this, and I would concur with that. But also I don't think you can blithely say, "Just stay the course, people," because there are some concrete things to do to check upon whether your portfolio is in good shape. So, the first thing I always say to anyone with long-term assets like stocks, to be able to ride out those inevitable troughs that we see in stocks, you need to make sure that your near-term cash needs are taken care of. So for people who are retired, that's one to two years' worth of living expenses socked away in very safe securities, certificates of deposit, money market accounts, and so forth.

Then for people who have short-term needs for income, whether it's to pay tuition or whether if they are still working, they would want to make sure that they have that three to six months' worth of liquidity reserves again in CDs or money market accounts. So make sure that you have that baseline amount of liquidity so you can cover near-term bills, and, to the extent you possible can when things are this bad-looking, you can tune out these gyrations because you know that you won't need to tap that capital anytime soon. That's my best piece of advice.

Glaser: Then if you are looking to maybe put some money to work, what are some ideas? Should you just throw everything in the market today or implement conduct dollar-cost averaging? What's really the way to approach that?

Benz: Well I would say, first take a step back and look at your asset allocation to long-term assets and see how that compares to whatever baseline asset-allocation target you've set for yourself. At this point a lot of people say, I have no baseline asset-allocation target, I say get one. Spend some time right now thinking what is an optimal stock-bond mix for my long-term portfolio given where I'm in my life; that's the next step. Then in terms of opportunism, I would actually turn that to you, Jeremy. I know you stay in close touch with our stock analysts and what they are thinking about the market. If it turns out that you need stocks in your portfolio, maybe look for those pockets of the market that appear to be undervalued right now.

Glaser: I think the stock analysts really are focusing in on high-quality companies with great competitive advantages, what we would call wide economic moats, and ones with just sterling balance sheets. I think we don't know exactly what the future is going to hold obviously. There could be more credit turmoil in Europe there, and there could be more dislocations to market. So, you want a company that really has the cash and the balance sheet. Just like for a personal portfolio you want that cash to ride out any dislocations. You want a company that's not dependent on short-term financing, but rather is independent on the whims of the banks to keep themselves in business. So, I think that a lot of those businesses are selling very cheaply. And I think that as the market continues to sell off, they are going to get even cheaper, and there could be some opportunities there to get into some high-quality names at a good price.

Benz: To me I think also maintaining that global mind-set is important, so for looking at tapered growth in some of the developed economies, maybe you want to have exposure to companies that are global in terms of their footprint and have made in-roads into some of the developing markets as well as in developed markets.

Glaser: Some great advice, Christine. Thanks so much.

Benz: Jeremy, thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.