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May 12, 2010

Market correction, we barely knew ye

The most common definition of a stock market "correction" is when the market declines by at least 10%. Situations like last week illustrate why common definitions can get a little tricky in practice.

djia-Apr23-May11-2010 Using the closing prices of the market indexes, we still have not had an official correction since the bull market began in March 2009. By that measure, the market fell just 8.4% in the recent weeks through last Thursday, May 6.

But if you use intra-day prices, from the high on April 23 to the low on Thursday, the market fell 12.6% — enough to qualify as an official correction. Given the unprecedented nature of last week's drop and the fear that accompanied it, I expect most investors will think of this as an official correction.

In recapping this "correction or not" situation, MarketWatch editor Nick Godt points out some interesting parallels between the news/market action of the past week and that of September 2008–March 2009:

If it felt in recent weeks like we were thrown back in time somewhere between the collapse of Lehman Brothers in 2008, the credit market freeze and the deep global recession that followed, it wasn't just a bad dream.

Exactly what I was thinking (I should have written it faster!). Last week's rapidly building fear about "contagion" spreading from the Greek debt crisis, the partial seizing up of the debt markets and quickly following plunge in the stock market — all of it felt very similar to the period in September–October 2008.

Thankfully, it was relatively short-lived, in part because of Monday morning's announcement that Europe had agreed on their own version of "Le TARP" — a stimulus and debt-relief package equivalent to nearly $1 trillion. How in the world they are ever going to pay for that is beyond me, but it can't help but remind us of the U.S. government's response in March 2009 when we passed our own stimulus bill and the markets roared back to life.

Make no mistake, this is merely "kicking the can down the road," much like our own stimulus package. The hope is that an organic recovery can take hold that will allow these monstrous debt commitments to be repaid over time. Whether events will play out that way remains to be seen.

While the long-term implications of this approach is unknown, it's worth noting what the U.S. financial stimulus did to the investment markets. They took off and didn't look back for a year.

That's not to say it was the right thing to do — there are more important considerations than the short-term boosting of the financial markets, and I think most of us have serious reservations about the price to be paid for all this in the future. But for the present, as investors, it would probably be foolish to ignore the potential implications of this second gush of liquidity into the system. If there's anything we've learned from the past 10-15 years, it's how responsive financial assets have tended to be to monetary stimulus and liquidity.

Some are pessimistic about the immediate impact Europe's problems are going to have on the U.S. markets. But it seems to me that this is yet another round of ammunition for a "great next 12-18 months, then watch out" scenario. Time will tell.

As always, attend to your immediate priorities (debt, savings) and don't take more risk than necessary in pursuit of your investing goals. That's one bit of certain financial instruction we can offer in these "interesting times."