Fear Causes Underinvestment Syndrome
It is very common for "fear of bad things happening soon" to cause investors
to hold significant amounts of cash, which can be extremely harmful to long-term
investment performance and your future quality of life.
A Chronic Condition Based On Fear
If you regularly keep cash on the sidelines, a previous research piece, Concerned
About Being Underinvested? You Should Be, provides specific examples
of how fear can impact your net worth and retirement income.
Action Cures Fear
If fear can adversely impact our lives, how can we reasonably reduce fear
of the unknown? The answer is by gaining a better understanding of investment
probabilities. If the probably of bad things happening is relatively low, we
can sleep better at night.
A Crash Can Come Without Warning...Right?
One of the most difficult investment risk-management events in recent market
history is the May 6, 2010 "Flash Crash". Can we use facts to help us better
understand the odds of a similar plunge occurring in 2015? After reviewing
the facts below, you can make your own call.
A Spike In Fear Well Before The Flash Crash
The Flash Crash occurred on May 6, 2010. All of the 2010 charts below are
as of May 5, allowing us to see the hard and observable evidence before the
Flash Crash. For example, the VIX "Fear Index" started to spike well before
the Flash Crash. As shown below, the VIX started saying "pay closer attention" on
April 16 when it broke a downward-sloping trendline. It went on to complete
steps 2 and 3 of the three
steps needed for a trend change before the end of April 2010 (or well before
the Flash Crash).
How Does The Same Chart Look Today?
Is the VIX showing a similar spike in fear in 2015? No, the present-day VIX
continues to make a series of lower highs and lower lows.
Extreme Fear Is Deflationary
When investors begin to become concerned about earnings and the economy, they
tend to migrate toward defensive assets, such as long-term Treasuries (TLT).
Bonds started to say "concerns are increasing" on April 7, 2010 or almost a
full month before the Flash Crash.
Are Bonds Indicating Increasing Fear Now?
Instead of making higher and fearful highs in recent weeks, TLT has been doing
just the opposite, making lower lows. The chart below, like the 2015 VIX, does
not align with increasing fear.
Stocks Gave Some Warning
When a trendline breaks, it tells us bullish conviction is starting to wane
relative to bearish conviction. As shown in the chart below, the S&P 500
broke a trendline in late April 2010, then went on to make a lower high (see
2) and a lower low (3). All three observable steps occurred before the Flash
Crash.
The S&P 500 Looks Much Better Today
Could the 2015 chart below morph into a more concerning look? Sure it could,
but that aligns with "fear of what may happen" rather than something hard and
observable.
Flash Crash Was Not Easy
The evidence shown previously (VIX and bonds) speaks to the concept of the
weight of the evidence. One of the more difficult aspects of the 2010 Flash
Crash was the S&P 500 had made a higher high just 8 calendar days before
the May 6 event.
Higher Highs Speak To Bullish Conviction
For stocks to make a higher high, the conviction to own stocks has to be higher
than the conviction to sell stocks. In 2015, the S&P 500 is only one day
removed from the most recent highest high. More importantly, unlike 2010, the
S&P 500 has not made a lower low recently.
The Broader The Market, The Better The Evidence
The S&P 500 contains 500 stocks. The NYSE Composite Stock Index contains
thousands of stocks, and thus gives a broader view of the stock market's overall
health. Did the NYSE send up some "be more careful" flares before the May 6
Flash Crash? Yes, the NYSE completed the 3 steps needed for a bearish trend
change in late April 2010.
How Does The Same Chart Look Today?
Bullish conviction was recently strong enough relative to bearish conviction
to push the NYSE to a new high and above areas that rejected price for over
nine months. Unlike May 2010, the NYSE Composite has several months of consolidation
below, which may attract buyers to provide support for stocks.
Global Stocks Showed Weakness In 2010
As shown in the chart below, global stocks (ACWI) completed the 3rd bearish
step on April 27, 2010, or well before the May 6 plunge.
A Recent Higher High In Global Stocks
We are no longer in a "the S&P 500 is the only game in town" market, which
can be seen via the recent bullish higher high posted by stocks from all over
the globe. Rather than seeing 3 bearish steps as we did in 2010, the same chart
in 2015 has recently completed 3 bullish steps.
Is The Risk Of A Crash Zero?
No, the stock market can do anything at anytime - nothing is guaranteed. However,
the charts above tell us the probability of a "crash-like" event occurring
over the next several days is significantly lower today than it was in late-April/early-May
2010.
Could GDP Tip The Scales?
It should be noted that this is a short-term analysis, meaning the probabilities
can change relatively quickly, highlighting the importance of ongoing assessment
of risk. The charts shown above reflect the "knowns" as of Tuesday, April 28,
2015. The poor GDP reading on April 29 is new information and will be reflected
in the charts during Wednesday's trading session.
The Evidence Will Guide Us
If the evidence begins to change, our market
model will assist us in making any necessary adjustments from a probability
perspective. Central banks around the globe have been extremely aggressive
with monetary policy, which means we respect the need for flexibility and
a disciplined approach to risk management. As 2010 showed us, things can
happen fast in the financial markets.
How About The Longer-Term View?
If you are looking for a longer-term view of risk on the global equity playing
field, this week's stock market video provides
over 30 different charts to help us better understand market probabilities.
