The Question On Everyone’s Lips… What Happened?

But the fact that it started in China was no surprise to me. I had written several pieces in the Global Guru about the dangers of the China Mania. That sell-off in far-off Shanghai triggered a sell-off in New York that shows how interconnected the world’s markets have become.

As a result, we were stopped out of three of our positions — ICICI Bank (IBN) in India, iShares Singapore ETF (EWS) and Unibanco (UBB) in Brazil. That’s not a surprise. India,  Brazil and Singapore tend to be the more volatile markets during times of uncertainty.

Despite their dizzying gyrations, the world’s financial markets are in pretty good shape. That doesn’t mean that the current sell-off can’t continue for a while. But it does mean that it is just another hiccup against a fundamentally positive economic backdrop.

MR. MARKET’S MOOD SWINGS

Nobel-prize winning theories about "rational expectations" to the contrary, investors are anything but homo economicus — the perfectly rational actor assumed by mainstream economic theory. Financial markets are much more like Mr. Market — the metaphorical manic depressive first described by Ben Graham and popularized by disciple Warren Buffett.

Some days, Mr. Market is euphoric. On other days, he’s very depressed. If you catch him on a euphoric day, he wants a very high price for his shares. If he’s in one of his down moods, he’s willing to sell you his shares for a pittance. This week, Mr. Market is in one of his down moods. Mr. Market highlights the one thing you can predict with certainty about financial markets: investors will always overreact to events — whether positive or negative.

REASONS TO BE CHEERFUL

First, the fundamentals of the global markets are strong. Investor nervousness notwithstanding, developing countries have much higher foreign currency reserves (savings) and they have lower trade deficits. And, much more of the $491 billion investment that they attracted last year is "locked up" in factories rather than in "hot money" that invests in stocks or bonds.

Second, emerging markets are only trading at a P/E of 12. Markets like India that were trading in the low 20s have been hit the hardest. The market sell-off was sudden, yes. But it’s not like we’ve been partying like its 1999. Things suddenly seem worse simply because they have been so unusually good.

WHAT TO EXPECT

Global markets have rallied strongly in four prior sell-offs (May 2004, March 2005, October 2005, May 2006) and it was smart to buy into the correction. Mr. Market’s mood swing proved temporary. The hardest hit markets — like India — have risen by more than 50% within a few months. John Kenneth Galbraith’s famous dictum once again proven correct: "The financial memory is very short." It’ll be a stock picker’s market between now and September, and in October we’ll see the traditional fourth-quarter rally in global bull markets. By then, this correction will be but a distant memory.

A QUICK TRADING TUTORIAL

Certainly the gyrations in the market can be unnerving. That’s why money management — how much you risk on each position — is so important.

Always calculate the maximum that you are willing to risk on each of our picks (the current price minus the recommended stop price). That can be $100 or $1,000 or $100,000. It’s all up to you. If the amount that you have at risk on any current pick makes you uncomfortable, just reduce the number of shares you hold.

A word about stops. These are carefully calculated, based on the stock’s own risk and volatility characteristics. That’s why we give a stock like Home Inns & Hotels (HMIN) a lot more room to breathe than a typically low-risk play like Singapore (EWS). The riskier the stock, the greater the price swings. I have calculated these stops so that you won’t get stopped out on the back of a couple of weeks of bad performance. But if we do hit a stop, make sure you sell. Remember, you’ll have a new trading opportunity announced in your inbox next week.

By focusing on how much you are willing to risk on a position, you are applying the same sophisticated money management principles that I use when I manage my own clients’ money. It’s the difference between being an "analyst" and a "money manager." Think of it as the difference between the radio announcer commenting on the baseball game ("easy" — everyone can have an opinion) versus the guy out there swinging the bat ("hard" — and you’ll need to break a sweat). Same game. Very different experience.

The bottom line? If you know how much you have risked ahead of time, you don’t need to be unduly unnerved by gyrations in the market.