The Insanity of the Market's Reaction to the Fed This Past Week

Investors' reaction this week to Ben Bernanke's comments about the future of the Federal Reserve's stimulus programs were nothing less than insane. Well, perhaps "insane" isn't quite right. The market has looked more like a toddler throwing a tantrum when a grown-up told him he can't have his way all the time.

The Dow Jones Industrial Average lost 1.79%, or 270 points, this past week. On both Monday and Tuesday of last week, the Dow rose by more than 100 points each day. But on Wednesday and Thursday combined, the blue-chip index fell more than 550 points, after the Fed chairman told investors that the central bank sees signs of a strengthening economy, and as that long as the economy continues down its current path, the central bank will soon begin slowing its stimulus programs. Cue the tantrum. The markets experienced their worst week in nearly two months.

Even though the Dow rose by more than 200 points during the beginning of the week, the past five trading sessions added up to the worst week since April 15-19, when the Dow lost 317 points, or 2.1%. But one big difference between this week and that one is that in April, the Dow had only 19 losers at the end of the week. This past week, 27 of the Dow's 30 components saw their prices decline.

Furthermore, back in April, the Dow's worst performer was IBM which lost 10.11%. The reason that matters is that the Dow is a price-weighted index, which means that stocks with higher prices have a larger impact on the index. Since IBM represents 10% of the Dow's total score, when it lost 10% in April, it singlehandedly cut around 160 points from the index, or around half of its loss that week.

This past week, in contrast, IBM lost 3.74%. That's still a large decline, but it represents only about 57 points of the Dow's 270-point loss. This time around, AT&T was the index's largest decliner, losing 4.47% this past week, but the stock represents only about 1.4% of the Dow, so it didn't play a major role in tanking the index. The next largest decliner, at 4.13%, was Travelers -- which, besides AT&T, was the only other component to lose more than 4% of its value. But, while Travelers' weight is substantially larger than AT&T, it still makes up only 4.1% of the index, ranking it as the 10th heaviest component.

The point is that this past week's drop was a broad market descent, meaning that stocks in general across the board declined in value, based on news at a macro level. As the old Warren Buffett saying goes, "Be fearful when others are greedy, and greedy when other are fearful." This is one of those times we should be getting greedy.

Bernanke's view that the U.S. economy is growing stronger should signal to investors that corporate revenues and profits should be rising in the future. If we believe that the long-term price of a stock is based on profits, then we should be buying stocks today, with the belief that we'll see higher profits in the future. In addition, when we see big market moves caused by macro events and not company-specific news, value investors should start salivating. The market is essentially selling shares of quality companies at a discount for no logical reason.

So why would stocks fall in reaction to Bernanke's comments? One view is that investors believe that when the Fed shuts down the free-money spigot, the economic growth we've seen over the past few years will come to a halt and we'll experience a period of extremely low GDP growth -- an environment in which corporate profits would struggle. The problem with this theory is that the Fed has told investors that if economic growth begins slowing after it ramps down its stimulus, it will come back in to give the economy another kick-start. That tells me the Fed will essentially backstop the market at a level it thinks is appropriate.

Final takeaway
If the markets fall even when the Fed talks merely about slowing its stimulus, and if the theory about a slow economy in the future plays out, we'll probably see a few more big drops from the market in the coming months. But if the markets continue to fluctuate, it should give long-term value investors some great buying opportunities in the future. Furthermore, if we practice the principle of buying in thirds, we should be able to fully build a position in the coming six to 12 months, during days or weeks when the market is falling because of macro events such as we experienced this past week.

More Foolish insight
The Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

The article The Insanity of the Market's Reaction to the Fed This Past Week originally appeared on Fool.com.

Fool contributor Matt Thalman has no position in any stocks mentioned. Check back Monday through Friday as Matt explains what caused the Dow's winners and losers of the day, and every Saturday for a weekly recap. Follow Matt on Twitter: @mthalman5513. The Motley Fool owns shares of IBM. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.