A touch of reality has hit the markets but investors are still in the “Twilight Zone.”
Although the bubble was nicked slightly, there’s still evidence of the euphoric stages of this nine-year U.S. bull market. The market is at levels that are, to put it bluntly, statistically stupid. For example, the S&P 500 SPX, +0.05% doubled its old high in less than two years, a remarkable achievement.
Lance Roberts, portfolio manager and market technician at realinvestmentadvice.com, recently wrote: “Currently, the market is pushing towards 4-standard deviations (99.9 percentile) above the 52-week mean…this is ‘rarefied air’ for the market historically.” Roberts notes that this statistical aberration hasn’t occurred since 1981.
He adds: “Previously, large deviations from a long-term mean have coincided with mild to severe market corrections and crashes. Given the current extreme deviation, one can only assume a negative outcome in the future.”
Put another way, although the U.S. market could continue moving higher and bring in more investors who want to join the party they’ve missed, the odds are good the worst is yet to come. Even scarier, technicians are expecting the market will eventually experience a “reversion to the mean,” that is, it will return to its average. In fact, as Roberts has said, even if the market fell by 10% or 15%, it would feel like a crash to most investors. If the Dow dropped to its 200-day moving average, which is not unreasonable, it would be near 22,600. That would cause a lot of anxiety and pain.
That’s why the market at this level is so dangerous and irrational; it can get even more statistically stupid before reality hits investors. You can keep volatility suppressed for only so long (or interest rates, for that matter) before reality returns.
Fear of missing out
It’s not just statistics that are flashing warning signs. The CEO of TD Ameritrade recently warned that cash levels at its brokerage were at historic lows. In other words, customers are buying at the all-time highs, going on margin, buying leveraged ETFs, all trying to make money before it’s too late. Forget about telling investors to sell, because they don’t want to miss out. There is little cash on the sidelines.
This fear of missing out (FOMO) is also reflected in investor sentiment surveys. Right before the recent market pullback, the Investors Intelligence survey reached historic levels of bullishness (a warning sign). Other sentiment surveys also reflect a misguided view that the market will never go down for long. In the event of a correction, it appears that many investors believe they can get out before real damage is done to their portfolio. It will be interesting to see how that works in action.
Remember, investors always sell in a panic at the bottom and greedily buy at the top. Does this mean the market will crash? Not necessarily — euphoria could last a bit longer. But one thing is clear: although the S&P recently reached its all-time highs, volatility (wild intraday swings) has returned to the market. That is a clue the market dynamics are changing. This also happened in 2007, prior to the 2008-09 downturn.
Knowledge and preparation are key
According to TheoTrade technical analyst Jeffrey Bierman: “Bull markets don’t die because of old age but they die because of statistical probabilities and measurements. Right now, the risk measurements are screaming, “take the money and run.”
Bierman says investors should not forget that the computer algorithms which have elevated the market to nosebleed highs in a short time period are the same mechanisms that can drive the market into the ground. “Risk cuts both ways,” he says.
So be prepared for the possibility the U.S. market will return to its mean. Most retail and professional investors will act like “deer in the headlights” once the uptrend cracks, which is why you should prepare now for a correction even if it doesn’t materialize immediately.
It’s essential that you learn how to protect your portfolios, limit risk, and manage a future bear market. As a hedge, learn how to use a small amount of money to buy put options.
Even with all these warnings, the final stages of the bull market could go on for a while longer because the alternative is so frightening. The wisest choice to survive a transition is knowledge, and that means having strategies and a plan. The last thing you want is to be caught off-guard or to rely on your emotions and instincts to get through a shifting, volatile environment. That is when investors switch from panic buying to panic selling, and it’s not a pretty sight.
Michael Sincere ( michaelsincere.com ) is the author of “Understanding Options 2E” and “Understanding Stocks 2E.”