The Cycle of Markets and Human Nature

Ahhh…that was nice…

Two weeks off. Spent with family and friends, eating and drinking too much, with plenty of sun and surf thrown in.

Downtime is crucial when you spend every day watching and thinking about the markets. You need to clear out the cobwebs that have accumulated over the past 12 months, reset, and get ready to go again.

It’s the same for most jobs, really. But I think especially so when you have a responsibility for guiding others to effectively manage their wealth. It’s a big responsibility, and one I don’t take lightly.

So here’s to a (hopefully) successful 2018. Last year was a good one. Subscribers of my investment advisory, Crisis & Opportunity, are sitting on some solid gains.

While I’d like to think that’s due to my stock picking skills, in reality, the market was pretty kind to most investors last year. As the saying goes, everyone’s a genius in a bull market.

The trick is to recognise this. The real skill comes in trying to navigate the inevitable correction. And on this front, I think you’ll see a decent one sometime this year.

I make this statement based purely on the balance of probabilities. Since late 2015 and early 2016, the S&P 500 has not experienced a correction of more than 5%.

That is an extremely rare bout of low volatility. I don’t have stats to back this up, but I believe for this lack of volatility to continue for another year would likely be unprecedented.

While you never know what the future holds, you can plan and prepare for more likely outcomes than others. That is, you can try and increase your probability of being right.

So starting the year with an expectation that the market could endure a correction of 10–20% at some stage is, I think, a sound and reasonable expectation.

Although you wouldn’t know that from the way the year has started. Neither searing heat in Australia (global warming) nor biting cold in the US northeast (global cooling) has had an impact on bullish market sentiment.

If anything, stocks have gained even greater momentum in the first week of the year. Check out the chart of the S&P 500 below:

S&P 500 9-01-18

Source: Optuma

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The index has gone vertical this year. At the very least, I would expect a correction back to the moving averages (MAs — the blue and red lines) at some point. The MAs in this chart are 50 and 100-day, which effectively represent short and medium term trends.

Even in upward trending markets, prices never stray too far from the MAs. Since this bull market surge got underway in early 2016, prices have dipped below the 100-day moving average on only two occasions. It’s certainly a buy-the-dip mentality.

If the market were to correct back to its 100-day MA (the red line) from here, it would represent a 6% decline. This would no doubt fire up the bears and bring about predictions of a crash and/or an end to the bull market.

But really, it would be entirely normal. A correction back to or slightly below the 100-day MA would do nothing to dent the overall bullish momentum. 

So I’d caution against panic selling in a ‘healthy’ correction. It will just feel much worse than it should because it’s been so long since you’ve experienced the fear of a decent correction.

If a big bear market is unfolding though, you should have ample time to get out. You just need to understand the signs.

For example, after a strong rally in a stock or an index, ‘distribution’ often takes place. This is where early investors slowly unload (distribute) their holdings to later investors caught up in the hype. These investors are not cognisant of extreme valuations or changing conditions.

Distribution patterns take time to unfold. For example, below is a chart of the S&P 500 in 2000. This was a major market top. In the following two years, the S&P 500 lost 50% of its value.

S&P 500 9-01-18

Source: Optuma

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The market peaked in March 2000. Volatility then picked up as the market fluctuated around the highs. This was a roughly six month period of ‘distribution’.

In other words, investors had plenty of time to see that conditions were changing. The problem is that in these situations, investors are usually so locked into their bullish narrative that they fail to remain open-minded. They fail to question their own prevailing beliefs. They fail to see what is really going on.

It is only when the market tells them, via sharply falling prices, that they wake up. By then it is too late. Emotions take over. They wait and hope for a bounce.

It never comes. Eventually, those who bought closer to the top give up and sell close to the bottom. This is how cycles work. It is a cycle of human nature and emotion. And it will happen again.

Whether that’s in 2018 or not is anyone’s guess. The key is to be open-minded, and change your mind when the facts change.

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:

Money Morning Australia