Markets looking for a reason to sell-off!

The New Year euphoria of the investment community did not last very long into 2006. US stocks gave back all their gains to date last week, and Friday's US sell-off will likely be followed by Europe and the UK where markets were closed at the time.

This is typical of a late-cycle market rally that has run out-of-steam. Last year US equities tracked sideways, now the market is probably turning downwards.

Is this not what you would expect in an environment of rising interest rates and very high oil prices with inflation rising? Company profit margins are going to be squeezed and this makes them worth less, although not worthless.

What is always required in financial markets is some unforeseen event to trigger a collapse of confidence, and to suddenly confront investors with the brutal nakedness of their position: that they are long on stock when the market is moving into correction phase.

Unforeseen events

Last week the revelation that Iran may be selling its European assets in preparation for a showdown over its nuclear program spooked US investors; no matter that this was later denied, and is just one step further in an ongoing row with non-nuclear Iran versus the rest of the world. A recording from Osama bin Laden also alarmed investors, but again this is not a new threat.

Earlier in the same week the Japanese stock market plummeted on irregularities in trading at an internet company, surely more a local problem rather than a reason to sell Japanese equities en bloc.

This looks more a matter of unforeseen events bringing investors face-to-face with an unpopular reality. High oil prices and the high interest rates needed at the very least to protect against accompanying inflation do not provide a good environment for the growth of company profits.

Spiral of decline

The danger is that a shift in market confidence at this stage also has a self-fulfilling side. For should investors dump stocks en masse, and perhaps decide that real estate also looks over-priced then a lot of people will be left nursing big losses.

This is worst for those investors who are over-borrowed as their losses may tip them into financial failure and bankruptcy. Markets then have a spiral of decline rather than a rally situation.

Is it therefore very surprising that gold and precious metals have rallied, and gold hit another 25-year high last Friday of $568 an ounce? The art of successful investment is after all incredibly simply: you buy asset classes that are rising in value and not those that are falling.

Crowd psychology and the 'safety of the herd' mentality make this judgment a tough call for many investors. Yet if you are not prepared to make this sort of judgment then as Warren Buffet argues a tracker fund held over time is the probably the best investment as at least it eliminates the foolishness of crowds!