Well, today the markets gave us a much needed breather…well a breather for those who wanted to buy stocks, and a down day for those who only want to watch what they already own rise.

So what caused today’s mini-correction? Here was a headline that I read that tried to explain it taken from CNNMoney.com:

“Brutal sell-off on Wall Street

Dow down almost 367 points, its third worst day of the year, on fears about credit and housing sector, earnings, record-high oil prices, slide in dollar, what the Fed will do next.”

Uh, say again? You mean today everyone woke up, and said, you know, I think I’m selling my stocks because well, earnings are bad, the housing stuff is really bumming me out, I just checked out oil prices and you know, they are higher today than yesterday, which is starting to freak me out, and even though the dollar has been declining for several months precipitously, TODAY it really means something, and to top it all off, what the heck will the Fed do next…you know what, I need to sell some stocks!

Ah, so THIS is why the market sold off today.

Now, I’m not trying to discount what is happening around us at all, because it does matter to a certain extent.

If people’s home values continue to decline, they can’t get loans to refinance, etc., panic will set in, and we’ll start spending less money. That’s a fact, and if that happens, businesses overall suffer.

And true too, that if oil prices continue to rise, the dollar continues to fall and access to credit becomes harder to come by, our spending power will diminish, which in turn will lead to businesses having to ratchet down earnings expectations, etc.

Effect On Daily Prices

BUT, what is not true necessarily, and what long term traders need to understand, is that rarely is any one event responsible for an entire market sell-off. From day-to-day fluctuations are normal and healthy.

A certain event (like the Fed lowering or raising interest rates) can be a catalyst for hedge funds, mutual funds and short term traders to begin closing out positions, which in turn creates more selling pressure as prices fall, and no one is there to support the prices, but if the overall fundamentals of the company you are invested in has not changed, these types of situations can present wonderful opportunities to grab more stock in a company you own or want to own, at cheaper prices, because it came along for the ride downward.

Something else to think about: Most of these funds and traders are using margin to buy and sell stock. Margin allows you to borrow money to buy more stock. This can be great when stocks are up because you essentially own more stock for less of your initial deposit, so your gains are out-sized, but the same thing happens when stocks sell off! Your losses can be double, and this causes a unique cycle of events that can sometimes lead to HUGE losses in particular stocks, and the market in general, very quickly.

As the chart on the left taken from an article I just read in on Barrons.com shows, margin borrowing is near its highest levels ever, which can and will be nasty when the market corrects.

Overheated Market

The market lately, and by lately I mean for about 5 years, but specifically the last few years, has been on an absolute tear, with gains in the Nasdaq, S&P 500 and Dow approaching 20% in just about 1 year’s time! If you’ve been paying attention, the average market return is about 10% per year over the life of the market’s existence, so we are far and away exceeding traditional market returns lately.

In fact just last week, the Dow reached an all-time high of 14,164.50 on Tuesday (10-9-07) and the Standard & Poor’s 500 also hit an all-time high of 1565.15 on the same day. The Nasdaq Composite Index reached a level it hasn’t seen for about 6 years!

With conditions like this, in a somewhat turbulent and uncertain time, market pundits, day-traders, hedge funds and the like, get nervous and any CATALYST can set them off, as we saw Friday.

I have a watch list of about 100 companies that I follow every day. I’ve been waiting for good entry points in almost all the ones that I have a serious interest in, but have been unable to pull the trigger as valuations are getting to a level that doesn’t make me feel like I have enough risk/reward protection.

Every day my watch list lights up like a Christmas tree with GREEN across the board. Friday was the first significant decline in some of these stocks for months, and it was a much needed breather.

In fact, in a follow-up post, I am re-recommending my first selection of AAR Corp. (NYSE: AIR), with another 1/4 position buy right now because of this discount.

So Now What?

Market volatility is rising and will probably get choppy from here on out. That means large swings up and down are possible as the larger market players that really move prices vacillate between buying and selling depending on their mood, and what they feel is going to happen in the next year.

To be honest, I would love to see stocks come down in valuation and price more from here. If we got a nice correction of say 10% or more, like we had a few months back when the Home Loan crises came to the fore, it would allow us to cherry pick the stocks that I’ve been watching and researching and waiting patiently to buy.

I sense that the time might come very shortly, when I’ll be sending out multiple buy recommendations and research reports as stocks decline with the overall market decline irrespective of each individual company’s fundamentals and prospects, which is a perfect time to add to our portfolio for the coming years.

Stay tuned!