Blood In The Streets - Part II
There’s an old contrarian investing maxim from Baron Rothschild that says “the time to buy is when there’s blood in the streets, even if the blood is your own.” This is also the hardest thing for investors to do because it runs against the grain of emotional biases. However, the best buying opportunities NEVER occur at the top of markets, which is ironically where most investors make investments, but at time of extreme panic when "weak hands" are selling out to "strong hands".
There is more “blood in the streets” today as the world continues to digest S&P’s downgrade of U.S. debt, the Eurozone crisis, riots in London, the weakening economic data, the lack of immediate QE from from the Fed and that is only a few on the list of concerns. The recent two-week blood bath has left little in its wake taking down everything in its wake with the exception of bonds (even though they were downgraded) and precious metals.
The reality is quickly setting in that there is a much larger likelihood than previously expected by mainstream economists that the U.S. economy could possibly slide back into recession. These concerns, combined with continued political/economic struggles in the Eurozone from socialist policies, have created a potent concoction of fear across global markets and sent volatility skyrocketing currently to its highest level since the May 2010 “Flash Crash.”
However, while many investors are running for the exits; we continue to be patient holding out sized levels of cash and fixed income in portfolios looking for the next great buying opportunity. Currently, we have nibbled very lightly on some index shares for an oversold bounce but in the intermediate term the path of least resistance for the market is lower. So, the question is why do we expect a short term bounce?
The S&P 500 Index has fallen over 15% over the past three weeks and has broken major support levels as well as having completed a "head and shoulders" topping formation. In the 3 days ending on Monday the markets fell 11% alone - that type of decline has only happened fives times since 1960: The 1987 Crash, the Asian financial crisis in 1998 and twice in 2008. Every time the market has had a rebound in the following month.
Furthermore, all of our indicators are also witnessing extreme oversold conditions with the CBOE Volatility Index (VIX) rising more than 46 percent to break the key 40 level, signaling an extreme event, and is up over 164 percent for the year. In general, any time the VIX reads above 30 means conditions are volatile. Above 40, it’s clear the only thing at a premium in this market is fear.
When there is extreme market turmoil it makes it very tough for investors as most individuals are linear thinkers when it comes to investing. Generally, investors believe that when markets are rising that they will continue to do so, regardless of the data, indefinitely into the future. Conversely, when markets decline far enough to elicit fear they likewise believe that the markets will go to zero. In reality, neither happens which is why we utilize a very conservative investment approach that participates in market rises while protecting portfolios from market declines. Trust me, we are never popular with our strategy in the media when markets are rising into their peaks because we are often promoting warnings. However, in times like these, we seem really smart. In reality, we are just prudent, logical and disciplined investors who try not to swayed by emotions but rather just follow the facts.
This chart shows sharp spikes in the VIX trigger sharp sell offs in the market. However, these sell offs have historically resulted in strong rebounds, thus providing an opportunity for disciplined investors to take advantage of emotional selling.
The VIX has closed above the 40 level five times since 1995, and in all but one occurrence the market was at higher levels just three months later. The exception is 2008, when the VIX passed 40 on its way to 90 and remained elevated for months during the worst financial crisis since the Great Depression.
Let me be clear. We are not saying that this is the next great long term buying opportunity. What I am trying to say is that nimble and disciplined investors can take advantage of an extreme oversold condition which will likely result in a short term bounce.
However, for many investors who are still carrying a lot of equity risk exposure we also implore that you do NOT fall subject to your emotional bias and sell at what may turn out to be a short term bottom. The best thing to do now is to remain calm and realize that we will get a bounce of somewhere between 6-9% historically speaking over the next couple of months to sell into and re-balance to a more conservative stance while we sort out the many issues that are currently facing the markets.
Remember, during an "average" recession stocks decline by 33% and with year-over-year profits now slipping towards a negative growth rate this does not bode well for the markets going forward from here so a higher degree of caution is advisable. While market sell offs are actually common this time of year, according to the Stock Trader’s Almanac, August has been the second-worst month of the year for the Dow Jones and S&P 500 since the 1987 crash. The 7.2 percent decline for the S&P 500 last week was the worst week ever recorded during the month of August, beating out another dismal week for performance in 1974.
With this in mind investors must remember the following things:
- The stock market has been the single worst performing asset class since the turn of the century.
- Cash, even at zero interest rates, is the best hedge against market volatility
- Cash also gives you the ability to be a buyer during times of market weakness
- Emotions never lead to good decisions
- A disciplined investment approach, but on a solid fundamental foundation, will lead to long term investment success.
- While a "rising tide may lift all boats" the opposite is also true.
- The trend is your friend always; and when the trend is negative - sell rallies
- Don't chase yield - yield is a function of risk and the losses of principal can far exceed the yield.
- Risk is never a function of how much money you will make - only how much you will lose when you are wrong.
- If you don't know what to do - do nothing. Generally, doing nothing works out better than panicking during market stress.