Putting The Market Mayhem Into Perspective

Tyler Durden's picture

Submitted by Lance Roberts of STA Wealth Management,

A recent CNBC article by Jeff Cox discussed that the current market rout stating:

"As hard as policymakers have sought to assure markets that they stand at the ready when conditions weaken, lack of a consistent voice has only spurred weakness, according to an analysis released Monday.  Emerging market economies are in turmoil as the Federal Reserve and its counterparts around the world look to unwind all the largesse of the past four-plus years.

 

Though economists are almost universally dismissing the impact of these smaller countries on U.S. growth, Wall Street is clearly on its heels after the worst January in years, and recent economic data show the recovery remains uneven at best."

I have discussed this issue numerous times in the past suggesting that when QE came to an end, so would the market rally.  What the Fed giveth, the Fed taketh away.  Jeff Saut recently summed this up well stating:

"Hedge funds have been borrowing money in Japan (again) at very low Japanese interest rates, obviously denominated in yen. They then convert those yen to, say, the Brazilian real, Argentine peso, Turkish lira, etc. and buy Brazilian bonds or Turkish bonds using 10:1+ leverage. Accordingly, when such countries jacked up interest rates overnight, their bond markets collapsed. Concurrently, their currencies swooned, causing the 'hot money' investors to not only lose on their leveraged bond positions, but on the currency as well.  If you are leveraged when that happens, the losses add up quickly and those positions need to be sold. So the bonds were sold, and the pesos/lira/real that were freed up from those sales had to be converted back into yen (at currency losses) to pay back the Japanese loans. And as the bonds/currencies crashed, the 'pile on' effect exaggerated the downside dive."

As the Fed continues to extract liquidity from the financial markets, it is likely that we will continue to see increased volatility in the markets.  However, despite the ever bullish calls by the mainstream analysts, the current market rout has awoken many overly complacent, excessively bullish, investors.  While the headlines make statements like "the worst start to a year since...," or "biggest one day dive since...," it is crucially important to retain some perspective. 

First of all, I have written multiple articles (see here, here and here) discussing the excessive extensions in the markets and that a correction of some magnitude was likely to occur this year.  However, the correction to date, is not "one of magnitude" as of yet, but rather a "dip" within the ongoing uptrend.  The chart below puts the current cyclical bull market, and current correction, into perspective. 

S&P500-Corrections

From the closing low of the markets in 2009 through today, the S&P 500 has risen by a total of 157.7%.   During that ongoing rise, there have been 13 corrections of which only 3 have been shallower than the current decline.

After an increase of nearly 30% in the markets in 2013, of which I have suggested numerous times that one should consider taking some profits from, it hardly seems alarming that the markets would experience at least some sort of mild correction.  So, at this point, will you please put your head back into the moving vehicle?

Now, before you think I have gotten all "bullish" on the markets, I assure you that I have not.  It is simply important, as an investor, to keep things in perspective in order to eliminate emotional investment mistakes.

“Acting without knowing takes you right off the cliff.” 

That quote from Ray Bradbury's "Something Wicked This Way Comes" has always stuck with me.  It epitomizes the actions of most individual's who invest in the markets.  They buy as stock prices rise and some guy is throwing bulls at the T.V. screen shouting "buy, buy, buy."  However, once prices begin to fall they fail to sell, well, because some guy is throwing bulls at the T.V. screen telling them not to.  Eventually, prices fall to a point where they push the "panic" button and dump their holdings into the market.

The problem is that most individuals act with knowing.  We witness the same behavior time and time again with an outcome which has never been good.  Despite words of advice from some of the great investors of our time such as:

  • "buy low and sell high"
  • "cut losers short and let winners run," or;
  • "buy fear and sell greed"

Retail investors repeatedly do the opposite.  As markets rise, and reach extreme levels of exuberance, it is only then that retail investors believe it is time to jump in.  Unfortunately, as shown in repeated academic studies, much of the average individual's behavior is driven by the self-serving interests of the Wall Street community that profits the most from retail investor's emotionally driven decisions. I discussed this at length in "The Truth About Wall Street Analyst:"

"Not surprisingly you are at the bottom of the list.  The incestuous relationship between companies, institutional clients and Wall Street are the cause of the ongoing problems within the financial system.  It is a closed loop that is portrayed to be a fair and functional system; however, in reality it has become a 'money grab' that has corrupted not only the system but the regulatory agencies that are supposed to oversee it."

The 5-panel chart below really tells you all you need to know about the current market environment.  We are overbought, over extended and exceedingly bullish.  The combination of these metrics has a history of bad outcomes.  Unfortunately, because these measures are generally overrun in the short term by price momentum and sentiment, they are disregarded as "this time is different."

5-Panel-Valuation-Chart-020514

While the current correction has certainly gotten everyone's attention, it is not really all that surprising.  Two week's ago I issued an "alert" signal in the weekly newsletter followed by a "sell" signal last week.  With the markets now very oversold on a short term basis, the odds of a bounce are quite high.  That bounce should be used to reduce portfolio risk and rebalance allocation models.  

With the Federal Reserve now seemingly committed to withdrawing support from the financial markets it suggests that there could be another 'leg' down in the equity markets before a meaningful price low is reached as the "risk-off" trade potentially becomes more pronounced.  As I discussed previously:

"The first misconception is that when the Fed tapers its ongoing liquidity program; interest rates will begin to rise.  However, there is no anecdotal evidence that would be the case as shown in the chart below."

QE-interestrates-112613

"In fact, the recent rise in interest rates should have been anticipated as that has been the case during both previous programs.   It was not until the programs began to 'taper,' and eventually end, that rates fell as money flowed out of risk assets in search of safety in the bond market.  This fall in rates also corresponded to economic weakness and expectations of an increase in deflationary pressures.

 

When the Fed once again begins to remove its accommodative support from the financial markets it will likely lead to a further decline in interest rates as 'safety' is once again sought over 'risk.'"

The current correction is certainly worth paying attention because of the triggering of the"sell" signal in our intermediate timing models.  This doesn't mean that the next great "financial crisis" is upon us, but it does suggest higher levels of risk currently.  While no one knows for sure what the future will bring, portfolio management is about the study of the probabilities of various outcomes both in the short term (technical analysis) and long term (fundamentals).  It is from this analysis that we can make calculated choices.  However, for most individuals who act upon headlines, and potentially biased commentators,"acting without knowing" generally leads to poor outcomes.

For many individuals, the best advice is to turn off the television, use the internet to view pictures of cats and leave the portfolio management process to someone who can remove the emotional bias from your money.