Today the headlines in USA Today credit a new Ebola virus case in the US for the 450 point drop on the DOW yesterday. Now the Ebola is obviously dangerous, but it does not cause the DOW to drop 450 points. The same style of reporting reported that the DOW could hit 20,000 by the end of the year a few weeks ago. The stock market, to some, is a psychological study of emotions (mainly fear and greed). When markets are moving up for long periods of time, greed can set in the markets. When the market drops like the past 4 weeks, fear becomes real. The headlines in the paper typically reflect the mood of the stock market. It took 9 months for the SP 500 to move 9% this year, it took 4 weeks to wipe away all of those gains. So fear is obviously the stronger emotion. Warren Buffet is quoted as “be fearful when others are greedy, and be greedy when others are fearful”. He is considered by most to be one of the most successful investors of our era.
If we take a look back at our market’s history we find some interesting facts to help with decisions. History can be much better than psychology when it comes to managing money. In analyzing the past 5 bear markets (when stocks drop 20% or more), we have had five corrections over the past 40 years. The average initial drop from the market high was 10.3%, with the highest initial drop of 13.8% in 2000. Yesterday, we dropped slightly over 9%. The current correction appears to be coming to an end, or should conclude soon. In studying the five bear markets of the past 40 years, the stock market rallied very quickly after the initial drop and regained back 78% on average of the initial drop. This, in Wall Street terms, is a “dead cat bounce”. If you are thinking about reducing your exposure to risk, history suggests that you wait to see what happens over the next few weeks. If we truly are going to drop 20% in equities, we should have a two to three week rally ahead, followed by a deeper correction in November/December. From my perspective, I do see this potential scenario ahead, but I need to see how the market reacts to this first correction. If the rally is straight up, that is not healthy. As I reported in the last communication, volatility is a sign of weakness, not strength, regardless of the market being up or down.
At IAP we are watching the markets very closely. If we get a “dead cat bounce”, we will be reducing equities on the rally ahead. I have heard in the news recently analysts discussing the 1987 crash. Well, I took a look at that crash. Interestingly, the first correction was 8.6%, followed by a rally that returned 70% of this loss (it was a dead cat bounce). So there was a warning. Corrections are hard to forecast, but if we have learned any lessons from our history, there are warning signs. I will update our blog every Friday to what I see happening in the weeks ahead.