Things Are Getting So Bad for Stocks They Might Be Getting Better…For A While

Estimated Reading Time: 6 minutes

A market this oversold will tend to rally at some point.

Markets have undergone a punishing slide of late. Stocks have been down eight weeks in a row. If we go another week, that may break the record set in 1923. The losses are not isolated but widespread. Something like 75% of stocks in the broad NYSE Index are below the 200-day moving average, a common indicator of longer-term trends.

Many of the broader indices have gone into “bear” territory, with a drop of 20% or more. The S&P, the indexer’s bellwether, barely escaped on Friday, May 20th with an inter-day move that hit bear readings during the day, only to be saved and reversed at the closing.

It has become common for 80-90% of stocks to either advance or decline on a given day. Everything has become more volatile and everything seems to be correlating together.

Bonds have been hit hard and have offered no protection. The commonly used 60% stock, and 40% bond asset allocation model has been a total failure.

Cryptocurrencies have tumbled with one major index down 80%. Perhaps the best of the group, Bitcoin, is down almost 60%.

Foreign stock markets have been weak, generally even worse than the US market.

Housing is starting to wobble.

Gold has underperformed expectations but at this writing is up about 1% on the year, about like cash.

The energy complex, utilities, and the US dollar have made positive moves so far this year. It has been a tough year to make money with few places to hide.

This should not come as a surprise to our readers because we have been talking about 2022 being a “risk-off” year for some time.

Readers need to keep in mind the peculiar math of bear markets. It takes a lot more than you think to get back even when you take large losses.

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The chart above certainly suggests avoiding a big drawdown in your investment accounts. Look at the upside move necessary to break even for the losses in cryptocurrencies!

However, bear markets, even big ones, are zig-zag affairs. There usually are some strong rallies, even in a bear phase. The irony is there is a point where things get so bad, that they start to look good for a while. Here is a quick update.

To more fully understand this, you have to appreciate that markets are made up of people. People can be both rational and emotional. They are rational most of the time but can get highly emotional at extremes. People tend to make decisions on an emotional basis.

Since it is people making investment decisions, (and even trading algorithmics are designed and implemented by people), the state of investor psychology becomes important to factor into the equation. Reading that state of market psychology unfortunately is more of an art form than it is a science.

However, those who do it for a living such as Jason Goepfert at SentimentTrader.com note that public pessimism is getting into extremes we have rarely seen.  Opinion poll numbers from investors and institutions are very low. Consumer sentiment is plunging as is the attitude of small businesses.

People are not only depressed by what they see, but they have also been selling heavily, and even small investors are now convinced to speculate on further downside action by buying record amounts of put options. We should add, that a put option gives the investor the right to sell at a lower price and is a way to make money if the market continues to fall.

Foreigners have also recently become big sellers of US equities, even though the US economy looks better than either Europe or Japan.

Last summer when we first started to warn you of market difficulties to come, we were in a distinct minority. That is not so today.

Attitudes have shifted dramatically and it seems just about everyone, foreign and domestic, now has a bearish opinion. In fact, Goepfert points out that on the Friday in question when the market reversed (temporarily or not), there were 3,700 bearish articles published about the stock market just so you could enjoy your weekend reading. We have not seen that kind of number in more than a decade.

Why is it good that everything is viewed so badly? Because all the pessimism is already in the price structure.  Usually, when we get into conditions like this, the market will do the opposite of what most people think it should do. Notice we are making an observation of market conditions, not a statement of timing.

Please don’t misunderstand. That pessimism may be completely warranted. However, all that pessimism is currently reflected in prices. Moreover, experience shows that when everyone thinks the same way, it is likely few people are thinking.

What usually happens (no guarantees in the prognostication business) is that the market will rally for a bit.  Bear market rallies in fact can be quite powerful. So powerful in fact that the bear uses these rallies to entice investors to get back in heavily just so he can have the joy to smash them again.

Given the view we have expressed in many previous articles, we think this will likely be a rally within the ongoing decline or what technical types call a contra-trend rally. The primary direction is still downward, but the market will likely rally for a while. In short, the market will still work lower than the recent low, but it will be interrupted by a rally phase. Only time will tell if that is correct.

While some may be able to make money with short term trading in such a rally, that is not our primary concern.  We suspect a lot of our readers have been surprised by how severe this market decline has been and how broad it has been, and wish now they had raised more cash and been more conservative.

Such a bear market rally is for nimble traders only. Long-term investors should use strength in the market to lighten up their positions or rotate into more conservative equities.

David Rosenberg, whose excellent presentation we ran a few weeks ago in our video section (you can find it in the archives), points out that never has the American public had this big of a chunk of their net worth in stocks. The rest is likely in real estate so bear markets in both those markets potentially could really crush consumer spending, which is 70% of GDP.

Thus, if you are in the camp that needs to de-risk a bit more, if we do get the relief rally the sentiment indicators suggest, it could be your last chance to get your asset allocation where you want it.

Well, what allocation would that be?  We can’t answer that for you because everyone’s financial situation is different and some people can run more risk than others. It varies so widely, that interpret these comments as descriptive, not prescriptive.

You likely need to have a conversation with a good financial planner if you have not already done so.

Why not just bail on the whole portfolio and go to cash? The main reason is intellectual modesty. No one really knows what is going to happen: how short or long, or how severe things might get if we slide into recession. There are too many independent variables. If you sell everything, you will miss the comeback, and unless America is permanently broken, we will come back. Besides, no one will ring a bell and tell you when it is time to get back in.

We also live in a world where a central planning agency of unelected and often unaccountable bureaucrats (The Federal Reserve Board), can change policy on a dime, and change market conditions almost overnight.  Unless you are privy to their secrets, you can’t know.

Therefore, it is better to keep some long-term positions because one just can’t know the outcome. What you can afford to hold through a recession is a matter of individual circumstance.

Having said that, with the multiple shocks of China closing down again, the FED taking the easy money away, the markets being overvalued, the public being overcommitted, food price spikes, oil price spikes, supply chain issues, a strong dollar hitting exports, corporate earnings likely to contract, and the system soaked with debt and overleveraged, certainly a more cautious view seems sensible.

If we get some kind of contra trend rally in the next few weeks, if you are really that smart, feel free to play it.  But for most of us mortals, it will just be the opportunity we need to get our market risk in line with our financial goals. That is if you have not already done that. If you are among the fortunate who are positioned comfortably, just sit tight.

If and when we get the rally, be grateful, as there are no guarantees we even will prove correct about the rally.

After the rally is over, the market will likely have the challenging task of repricing itself to accommodate more difficult conditions.

Hopefully, elections will sweep from office many of those inflicting such harm on the markets and the economy. That is another reason not to give up hope.

The coming election in the fall offers some optimism for a more durable turn. For the sake of your portfolio, your budget, and your country, we all need to work together to drive the current incompetents from office. That goal is perhaps the best investment you can make.

 

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