Market trends are not driven by emotions

It’s a lot of fun to talk about market sentiment – bulls vs bears, greed vs panic and all that.  Just remember that sentiment only drives near-term lows and near-term highs, not the overall direction of the market.

Right now we’re in a bear market and bearish rules apply.  That includes looking at charts like this:

Bear flag or bull flag.jpg

A typical bull flag formation is a sideways or downward consolidation trend off of a larger upward move.  A bear flag is a sideways or upward consolidation trend off of a larger downward move.  I think it’s obvious which one we’re in.

Think of the overall stock market as having both long term and short term capital flows.  Sentiment drives short-term flows from money that is temporarily entering or exiting the market – like a typical wave in the ocean.  So what drives the long term flows and how does that relate to bull versus bear markets?  In short, it’s the economic cycle.

Think about all of the pro-cyclical forces that helped push the stock market higher in the last 10 years.  The economy is doing well, corporations have more money to spend and they throw it into stock buyback programs.  Unemployment is at record lows and a lot of people are putting money into 401k’s.  Investment banks see asset gains, allowing them to borrow more money to put into the market (they call this leverage).  Low interest rates drive this further as corporations borrow even more money for stock buybacks, big investment firms borrow even more to invest in stocks, and many investors turn away from bonds because of their tiny returns.  With all of these forces pushing money into the stock market, it’s going to rise.

Now comes the Covid-19 shutdowns.  The economy goes from full speed to a near standstill in many sectors throughout the world.  People are laid off in record numbers.  Big companies cut their buyback programs as they brace for an earnings hit.  Those who lose their jobs are not putting money into 401k’s, even if they get beefed up unemployment checks … they save for when that 13 weeks runs out.  Many people who are still working see their hours cut or worry about a potential slowdown.  They already lost a bunch of value in their 401k’s so it’s easy to elect to put less money in.  Investment banks have to raise capital as money is pulled – often from clients who suddenly need it to help cover expenses while revenues are down.  Asset prices see writedowns and they need to reduce leverage to avoid margin calls (forced sales to ensure that they don’t owe more than their stock portfolio is worth).  With all of these forces either drastically reducing the amount of money flowing into the stock market or even pulling it out, it’s going to fall.

My advice to my friends in a situation like we have today is simple.  Sell your stocks, put your 401k into the safest possible setting, and wait until the social distancing period ends.  You might miss a big wave from sentiment at the very bottom, but that wave won’t make up for the money lost between here and the bottom.  It’s better just to wait until the tide starts to rise before you get back in.

A few more things to note:

  • Between 2007-2009, SPY went down about 68% and the 2007 highs weren’t reached until 2013.  Currently, SPY is down only 25% from the peak, which was only 6 weeks ago.
  • Part of the reason that the market came down so fast was because of the incredibly high leverage that near zero interest rates for 10 years builds up.
  • In my opinion, all of the “pre-emptive” fed rate cutting and balance sheet expansion done in 2019 only served to juice the markets a bit higher (with a bit more leverage) before the crash so they’d have that much further to fall.  Between October 2019 and the peak, SPY went from 288 to 338 – more than a 17% percent jump – which immediately unwound resulting in one of the fastest market crashes we’ve seen.
  • Remember, the overall tide is relatively easy to gauge … just ask yourself if corporate earnings overall are going to rise or fall in the next quarter, and if jobs are going to be created or lost.  In this case, it seems an easy bet that these will all be getting worse the longer the lockdowns persist, and then getting better once they come to an end.  As the economy picks up, it will regenerate those money flows into the stock market creating that rising tide of the next cyclical bull market.

 

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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1 Response to Market trends are not driven by emotions

  1. heliumspark says:

    There’s so much variation day to day. If I dump my TSP into the G fund, I wonder how long the actual reallocation will take behind the market. I tried today, but the TSP site was “down for maintenance”…

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