Vegas Rules

Though the recent drop in the stock market is no more extreme than similar ones in March and June, this one, or some one of the next ones will constitute an important announcement about the future of the economy. The moment of "importance" will be a fall of the Dow Jones average below 3,600, followed by a likely drift to even lower levels.

Most of what we think we know about the stock market has changed in the last dozen years.

First, there has been a dog and tail reversal between stocks and "debt" securities. Debt securities cover the whole range of promises by somebody to pay somebody back: bonds (Treasury, corporate, municipal, mortgage, and junk) and their shorter term siblings, notes and bills.

A short dozen years ago, the total value of stocks exceeded the total amount of debt outstanding. Today, total debt is a bigger sum by perhaps three times. Old-style statements are still common, but largely wrong: "A falling stock market helped bonds as investors shifted funds into the debt market." Vastly more likely: bond yields are falling in anticipation of a weak economy, and prospects for the same weak economy hurt stocks.

The bond market is so big that stocks can't move it; bonds now move stocks.

The second big change has to with new understanding how to invest succcessfully in stocks. The old method was to try to pick individual stocks. "Consolidated Flange looks like a great buy among the small caps despite its high P/E ratioÉ" You would never know it from watching CNBC or Wall Street Week, but this strategy is almost completely discredited for any but professional investors.

The new belief in success has to do with betting on the market as a whole in the broadest possible diversification. Half a trillion dollars worth of new mutual fund investments are testimony (as is "Capital Ideas" by Peter Bernstein, a murder mystery of the development of investment ideas).

It seems that if you buy the stock market as a whole, it's hard not to earn 10% per year compounded. However, as last week's little air pocket reminds, stock market returns are anything but steady. The market as a whole can have a few negative years in a row which are offset by big positive ones.

The third relatively new understanding of stock market investing is that it's nearly impossible for individual to "time" the stock market, meaning to know for sure when to sell before a drop, or buy before a big rise.

Which brings us back to the potential for an important announcement.

Though timing is inexact, the stock market tends to suffer a significant decline six months to a year before the economy suffers the same event. The stock market tends to overpredict, not in magnitude, but frequency. The oldest line about this predictive value is Paul Samuelson's, paraphrased as: "The stock market has predicted 17 of the last nine rcessions." False alarms define the game.

The Thanksgiving week 167-point crater is not definitive. So play odds, just like investors.

Think of the stock market as a Las Vegas casino. If you are going to play roulette, or craps, or twenty-one, the odds are stacked in favor of the house, maybe 53-47, depending on the game. Our stock market casino is a pleasant sort, where the odds are stacked in your favor 55-45, representing that 10% long term return.

Imagine that you are at the stock table, and the loudspeaker in the casino crackles to life, and a dour voice, much like that of a certain Fed chairman says: "Due to a policy change, our odds are now 50-50."

Oh, well. we could do worse at craps. Keep playing.

A little later, same voice: "Due to inflating costs, our odds are now 45-55."

We're having fun aren't we? We're pretty good at the game. We've bought some emerging markets and sector funds. Let's see if we can't outsmart this thing.

"Due to continuing price pressure, odds are now 40-60."

Gee, honey, how about we walk over to the Sands, and catch Henny Youngman?

If it weren't for the persistent fellow on the squawk box, things might be a little more uncertain. It's nice of him to give us so much warning.