The Current Sell-off and the Chicken Little Syndrome

By Ernie Ankrim, Ph.D., Chief Investment Strategist
Russell Investment Group
August 31, 2007

Many of us remember the old fable about Chicken Little. This skittish creature feared that the sky was falling and became a symbol of hysteria. Of course, even if you haven't read the fable—or seen the recent animated movie—you probably guessed that the sky remained perched securely above us.

In the face of the current sell-off that started July 20—a sell-off that certainly must be taken seriously given its short-term impact on investors' portfolios—I suggest that the Chicken Littles you may run into have it wrong as well. Here's why.

First, although no stock market index can be invested in directly, they are a reasonable representation of what's been happening for equity investors. A sense of the investor pain can be seen in the movement in the indices between July 20th and August 15th. Over this 26 day period the large-cap Russell 1000® Index fell by 8.6%, the small cap Russell 2000® Index fell by 10.1%. The S&P 500 and Dow fell similarly. Frightened investors can be forgiven for fearfully looking skyward.

The sell-off reflects both a financial event and an economic slowdown. Regarding the former, quantitative investment managers with computer programs played a major role. While computers can analyze specific numerical factors and take the emotion out of buy/sell decisions, they can't read The Wall Street Journal—or Russell.com—for news that can't be expressed by numbers. Further, quant managers tend to have a value orientation, and we've been in a growth environment.

All that being said, due to a bit of late August stabilization, the Russell 1000 year-to-date through August 30, was ahead by 4.06%. The Russell 2000 had gained 0.17% for the year. There is an important lesson to be learned—or reminded of—here.

Up means down and down means up
Market trends are just that—general senses of direction. Historically, the market trends upward. That's a simple fact, and if you're a long-term investor who hangs on during downturns, your portfolio—probably still larger than it was 18 to 24 months ago—delivers that message quite elegantly. But market momentum doesn't travel in a straight line. Bull markets feature negative trading days and weeks just as bear markets have positive sessions.

In short, volatility happens. From time to time, it gathers like storm clouds over a mountain peak. A correction turns the market down for a time. We can't know how long that period will be, and we might get a bit wet, but the foul weather ultimately clears.

For a good example, let's look back a decade. In 1998, the failure of Long Term Capital Management, a hedge fund founded in 1994, caused a volatility spike. On July 17, the market began to sell off. Over a period of four weeks, the S&P 500 lost 10.5%. From August 15 to September 25, when the Federal Reserve Board stepped in, the market dropped another 3%. By October 8, another 10% decline brought the total market drop to over 20%. How did that impact investors?

Through the rest of 1998, the market rose 30%. Investors who refused to imitate Chicken Little did very well.

Will we see a similar pattern this year? There's no way to make such a prediction. True, the market has been down as much as 10% from its July high—less than that as I write. That's not good. But we've seen a lot worse in recent years only to move up again. Given the rapid run-up to that high, investors who stayed calm remain in relatively good shape.

Moreover, on August 17, the Fed responded to a slowing economy by cutting its discount loan rate by half a point. This seems to have helped stabilize the market. The September 18 Federal Open Market Committee meeting will reveal how much more aggressively the Fed will act. But we do know this: historically, when the Fed has behaved responsibly to meet economic challenges, markets have recovered.

The need, yes need, for volatility
None of us likes to see our investments lose value. But long-term investors actually require volatility. Without a measure of risk, potential reward would plummet. And let me emphasize that over time market returns have provided significantly greater than those for savings or money market funds.

As to the future, we can make a good case that the market, which has recovered from the damage suffered in the early 2000s, is not overvalued.

Cool heads will prevail
What to do? Stay cool. If you have a long-term time horizon for your investment goals, a financial professional to assist you and a sound plan in place, most likely the best thing you can do when the markets begin rattling like thunder is stand pat.

So if a Chicken Little tells you to sell everything, think about where you'd like your portfolio to be 10 years from now, point upward and then point out that the sky isn't falling at all.

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This is a publication of Russell Investments. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.

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