Submitted by Jean-Yves Dumont via Evergreen Gavekal [5],
For the last two and a half years since June 2012, the best strategy for global equity investors has been to buy on dips. The strategy worked because of a very high level of market resilience combined with a (sometimes excessively) optimistic environment. As a result, over the last couple of years markets have tended to recover very quickly from shallow corrections.
However October’s relatively deep and protracted correction caught investors by surprise. The S&P 500, for example, fell almost 10% in a matter of weeks—something that had not happened in more than two years. In consequence the buy-the-dip strategy did not deliver its expected result. This came as a shock; implied volatility reached an intraday high not seen since late 2011.
My method of analysis relies heavily on technical signals, which led me to believe that October’s correction would be a game changer. It looked as if that the impact would take effect on two levels:
Steeper and longer corrections appeared to be back. Going forward, this implied that in times of uncertainty volatility would spike higher.
Investors would think twice before buying dips. Given the adverse surprise they suffered in October, it seemed likely the dippers would be more patient about buying in future. This was pure investor psychology at work.
In December, it looked as if markets disproved this thesis. A small correction started during the second week of the month, but it did not last for long. The dippers quickly returned in force, and some indexes delivered astonishing returns over the next few trading days, subsequently going on to post new record highs little more than a week after the rebound.
But is the December correction really over? Yesterday’s selloff was brutal. And in contrast to the patterns that prevailed over the last two years, the resurgent nervousness among market participants is striking just three weeks after the last rebound. That means yesterday’s sell-off may simply be the second leg of December’s correction.
[6]
Where could this second leg take us? First and foremost, let’s wait for today’s confirmation before jumping to conclusions. A lower open in Europe and/or a new intraday low in the US will provide a clearer picture.
But let’s assume that is what we get. The confirmation of a worsening environment would substantiate the change of market regime. Buying dips would become more dangerous. But more importantly, greed/resilience/excess optimism (call it what you will) could turn into another psychological phenomenon: fear.
There are two basic types of fear: the fear of missing out and the fear of losing. The second is more important in the current context. It is the fear of loss that prevails in uncertain times. Some might say that it should not apply today, as the US economy is growing sharply, peripheral spreads are low, and the price of oil is falling, which is good for consumers. Even so, could the fear of loss stage a comeback tomorrow?
To identify fear correctly, it is necessary to monitor several aspects:
The fear of losing money. Everybody hates losing money. It makes us nervous. These nerves can be observed in the option markets (put volumes, implied volatility, volatility curves, etc.). But it is the beginning of the year and there is still plenty of time to recover possible losses. This aspect of fear should be playing a minor role today.
The fear of bad news. This can be any news: Grexit, the oil price slump signaling a weaker-than-expected economic environment, high yield spreads widening as earnings disappoint, etc. This form of fear can be analyzed by looking at markets’ reaction to news. Since June 2012 markets have been in “all news is good news” mode. Could they now be about to switch to a more classic “good news is good, and bad news is bad” mode?
A fearful mass psychology. The contagion of fear among investors is a crucial factor. It is why it is so important to look for confirmations when making investment decisions. Most investors watched yesterday’s market action without acting (probably for legitimate reasons). But will they be so sanguine if the sell-off continues today and over subsequent sessions? Will they remain passive, or will they join the herd? In other words: will fear breed more fear?
There is no real conclusion to all this. What I want to stress is that fear is highly dangerous if it is contagious. As always, the market action will tell.
