It’s sure been an exceptionally-ugly
week in the US stock markets! The threat of Washington defaulting on its
debt, worse-than-expected economic data, and the waning of Q2 earnings season
conspired to wallop equity prices. The resulting sharp selloff has led to
soaring anxiety and fear, traders are rushing for
the exits. But these scary conditions are a contrarian’s dream, an
ideal time to snatch up bargains.
Legendary investor Warren Buffett is a bottomless
font of fantastic investing wisdom. One of my favorite quotes from him is
“Be brave when others are afraid, and afraid
when others are brave.” This simple concept is the core foundation of
all contrarian speculation and investment. If you want to buy low and sell
high, the best time to buy low is when everyone
else is scared. It is their collective selling that drives stocks to
deeply-oversold bargain prices.
And with the flagship S&P 500 stock index (SPX)
plunging 6.8% in just 7 trading days by Tuesday, naturally the majority of
traders are afraid now. They are selling with reckless abandon, fretting
about Washington’s out-of-control spending, European sovereign debt,
poor economic data, and all kinds of other things. Thus stock prices in
popular sectors from technology to commodities have been crushed.
Our natural instinct during such carnage is to join
the frightened herd in racing to dump stocks. The great majority of traders
lapse into this groupthink behavior, being
afraid when others are afraid. But for the contrarians who’ve
trained and hardened themselves to fight the crowd, intense selloffs are
harbingers of great opportunities. Aggressively buying stocks in their
fear-filled hearts nearly always leads to huge profits within a matter of
I’ve been a contrarian speculator and investor
for decades, so I’ve experienced countless times how challenging it is
to be brave when others are afraid. Buying into a fear maelstrom is never
easy, as there are always endless reasons advanced why stocks ought to
imminently plunge much lower. But this strategy’s fruits are wildly
profitable. Over the last decade,
all our newsletter stock trades
have averaged 50%+ annualized realized gains!
The key to fighting the fear in your own heart, to
forcing yourself to buy when everyone else is selling, is perspective. The tyranny of the
present hugely distorts our worldview, we all want
to extrapolate current events (in the markets or life in general) as
persisting out into infinity. But just when things seem least likely to
change is right when a major change is probably coming. Charts really
illustrate this in the markets.
Considered even in the brief context of 2011 alone,
this past week’s SPX selloff is no big deal. The stock markets have
been meandering in a broad trading range all year, surging up when traders
feel optimistic and slumping down when they feel pessimistic. Understanding
the SPX’s ongoing consolidation is crucial to recognizing the awesome
buying opportunities these weak stock markets have created.
The flagship S&P 500 stock index is the best
representation of the US stock markets as a whole, as well as the performance benchmark for all
stock-market professionals. Despite some big swings, on balance all this SPX
has done in 2011 is grind sideways
in a high consolidation. This trading range’s overhead resistance has
been around 1340 in SPX terms, while its foundational support has
crystallized near 1270.
Consolidations exist because sentiment, how traders
as a group feel about the markets, gets out of balance. After stocks rally
far enough and long enough, traders forget the markets are risky and grow too
greedy. This happened after the powerful 30.2% SPX upleg
between late August 2010 and mid-February 2011. By the end of this awesome
6-month run, traders feared nothing and assumed stocks would keep rallying
But the SPX was very overbought, stocks had rallied too far too fast to be
sustainable. By February this index was stretched 15.2% above its 200-day
moving average! The SPX’s relationship to this critical technical line
is rendered on this chart in the form of the Relative SPX in light red. It is
simply the blue SPX line divided by its black 200dma line. The resulting
multiple charted over time forms a horizontal trading range, as explained in
depth in my essay on Relativity Trading.
Over the past 5 years, the SPX has generally topped
when it stretched 10%+ beyond its 200dma. So 15% in mid-February was pretty
extreme. I warned our newsletter subscribers about this at the time, and we
realized big profits in our commodities-stock trades that had been added in
the summer of 2010 the last time traders were afraid. And indeed, after
hitting a new post-panic high of 1343 in mid-February, the SPX soon plunged
in its first pullback of 2011.
Though it was the Libya revolt that acted as this
selloff’s original spark, the particular catalyst that initially sends
an overbought market lower is irrelevant. If catalyst A hadn’t driven
the necessary selloff, then catalysts B or C soon would have. There is always
plenty of good news and bad news out there for traders to digest, so they can
easily spin prevailing newsflow to rationalize any buying or selling.
By several weeks later in mid-March, the SPX had
fallen 6.4% in its first pullback. Despite this selling event straddling the
terrible Japanese earthquake, tsunami, and Fukushima nuclear disaster, the
SPX rapidly V-bounced out of the resulting oversold lows. It only spent a
single trading day closing under 1270, the level that would later define its
2011 consolidation’s support.
Thinking back to market psychology near these
mid-March lows is very useful for putting this week’s events in
context. Back then, the country with the third-largest economy in the world
was devastated. This had major bearish implications for global trade and
economic growth. The first melting-down nuclear reactor in a quarter century
threatened to spew radioactive debris into the atmosphere and ocean that could
poison large swaths of our planet.
Traders were understandably very scared, as
evidenced by the brutal 5% SPX plunge in a single trading week! Nevertheless,
despite all these fears the SPX still V-bounced sharply as you can see in
this chart. Now it’s certainly not that the Japan crisis improved in
late March, actually the extent of the damage grew even worse as time allowed
a deeper examination of the aftermath. US economic news wasn’t great
either. But the stock markets still rallied sharply simply because they had
been far too oversold.
The SPX’s big bounce stalled near its 1340
resistance in early April, but some high-profile Q1-earnings-season beats in
late April temporarily drove this headline stock index above this line. But
right after hitting a new post-panic high of 1364 in late April, the SPX
started rolling over. This selling was moderate in May, but accelerated
dramatically in early June. Again the SPX plunged 5% in about a week.
This early-June pullback’s boundaries were
pretty interesting, as the meat of it started near 1340 resistance and it
bounced right at 1270 support. While the SPX would spend a few trading days
closing under 1270 before the stock markets rallied out of these lows again,
this support essentially held as this chart shows. Together these two major
bottoms defined this consolidation’s current trading-range support line.
Now as a contrarian speculator and investor, I was
certainly disappointed with both of these pullbacks that bottomed in
mid-March and mid-June. Given how overbought the stock markets had become in
mid-February, I expected to see a
full-blown correction. Corrections are bigger declines than pullbacks,
with the line of demarcation separating them at 10%. Outright corrections are
far preferable to pullbacks and consolidations for a variety of reasons.
Corrections, pullbacks, and consolidations all exist
to rebalance away the excessive greed and complacency seen at major interim
highs. The only thing that can combat these herd emotions is weak stock
markets. Corrections are superior because they condense this painful process
into the shortest-possible timespan, leading to oversold bargains and great
buying ops much sooner. Pullbacks
drag this rebalancing process out longer, while consolidations (sideways
grinds) are much slower still.
If the SPX had actually fully corrected instead of
just pulling back in March or June, we would have seen this week’s
stock bargains way back then and been well into the stock markets’ next
upleg by now. But a consolidation punctuated by
smaller pullbacks takes a lot longer to rebalance away excessive greed and
complacency. So when the SPX bounced in late June after two potential
corrections failed to materialize, it became readily evident we were stuck in
a grinding consolidation.
And indeed the SPX soon rocketed nearly 6% higher in only one week leading into July!
This anomalous huge surge was not news-driven, there was little happening
heading into the slow Independence Day holiday in the States. But low-volume
buying pressure still materialized, driving the SPX to catapult rapidly from
its 1270 consolidation support to its 1340 consolidation resistance. After
briefly surging over 1340, the stock markets immediately rolled over and
slumped until Q2 earnings season arrived.
Much like we had seen back in late April on the Q1
earnings, Q2’s in late July drove a minor SPX rally. But again the SPX
couldn’t break decisively above its consolidation resistance no matter
how amazing some of the high-profile earnings reports happened to be. And then
again just like it had done heading into early June, the SPX plunged straight
from resistance to support over this past week. Fast trading-range selloffs
aren’t uncommon as major consolidations mature.
Last week I figured the SPX’s 1270 support
line would hold in this selloff just as it largely did in mid-March and
mid-June. But obviously the SPX kept right on plunging this week, knifing
through 1270 on growing fears of an economic slowdown here and abroad. Is the
failure of this consolidation’s 1270 support a big deal? I doubt it. So
far this year the SPX has been able to occasionally
trade over resistance and under support, yet these extra-trend price levels
have never persisted for long.
By Thursday the SPX had spent three trading days
under 1270 this week, compared to one in mid-March and three in June. Rather
than being a threat, these sub-support days are a great opportunity. The lower the frightened herd irrationally
drives stock prices, the better the entry prices for prudent contrarians who
can buy into all this fear. This sub-support plunge also greatly increases the odds that this selloff is not only over or
soon will be, but will lead to a new highly-profitable sustained cyclical-bull-market upleg.
Corrections are superior to consolidations for
rebalancing sentiment because they drive stock prices deeper into oversold
territory which ignites far more fear. At 0.975x its
200dma as of Wednesday’s close (the data cutoff for this essay), the
SPX was as low relative to its 200dma as we’ve seen in this entire
consolidation. Check out the light-red rSPX line
above. It was also low in an absolute sense, nearing the 0.95x strong-buy signal in my Relativity trading system.
And this past week’s fast SPX plunge drove the
first meaningful fear spike we’ve seen since mid-March. The best proxy
for fear in the stock markets is the old-school VXO implied-volatility index.
I recently wrote an essay on using it to trade stock fear, to
buy stocks when the VXO surges in meaningful spikes and then sell stocks when
the VXO drops too low again. These spikes mark major bottoming events, fantastic times to aggressively buy
After the VXO’s sharp spike in mid-March as
this consolidation’s first pullback plunged under the SPX’s 1270
support, this headline stock index powered 8.5% higher over the subsequent 6
weeks. But during this consolidation’s second pullback bottoming in
mid-June, there was curiously no meaningful fear spike. Without it, the SPX
limped along near support for weeks before another rally could mount.
But during this past week, we have seen a new
meaningful fear spike which is very
bullish. The VXO had closed as high as 26.2 before the Wednesday data
cutoff for this essay, and it traded much higher intraday on Thursday as this
fear-laden selloff intensified. Since this SPX cyclical stock bull was born
in March 2009, the average VXO close
near the bottoms of every pullback and correction was 28.3. This week we were
once again pushing this high-probability-for-success buying territory.
A steep selloff, surging fear, and traders exiting
stocks in droves? It’s hard to imagine a better “be brave when
others are afraid” scenario! The hardened contrarians who’ve
painstakingly trained themselves to ignore their own innate greed and fear
have a wonderful opportunity to buy low
today. The great majority of traders are running scared with the herd, their
selling driving stocks down to irrational, oversold, and unsustainably-low levels.
I’ve written many similar essays deep in major
past selloffs, and the feedback is always similar. All of this contrarian
stuff sounds logical, people reason, but how can we know when a selloff is over? How can we know where it’s going to stop, in pullback territory or
stretching into correction magnitude? The truth is we can’t know, we mere mortals can
never see the future. All we can do is game probabilities, nothing more. And
the odds for a sharp rally immediately
after a fast selloff and meaningful fear spike are very high.
Just like in March, the interim lows after fast
selloffs like this week’s seldom persist for long. So buying a little
early in one of these selling events is no big deal at all. Even if it
isn’t over yet, and your stocks plunge lower with the markets, within
weeks they will still have surged far above your entry prices. Personally
since I can’t know the exact days of bottoms in real-time, I
intentionally try to straddle my stock deployments across them to maximize my odds of getting the best entry prices.
Some stocks are bought before the bottoming, some during, and some after. But
all still surge dramatically as the SPX recovers.
The biggest threat in a major selloff like this is
not gaming exactly when or where it will bounce, but whether it marks the
transition between cyclical stock bull to cyclical
stock bear. Buying stocks early in bear markets obviously leads to big
losses. So if careful study and
analysis (never merely selling-event emotions) lead you to believe we are
entering a new cyclical stock bear within today’s secular stock bear,
you definitely don’t want to buy stocks even given today’s oversoldness and meaningful fear spike.
But as I analyzed in depth in an essay in late June,
the bull-bear cycles today argue that the past couple years’ cyclical
stock bull likely remains alive and well. The probabilities of a new stock
bear being born this summer remain
fairly low. And there is definitely almost zero risk of another panic or crash so
soon after 2008’s epic selling event, as I explained last August as
traders also cowered in irrational fear. So with more cyclical-bull rallying
likely, this buying opportunity ought to be seized.
At Zeal we have been doing exactly that, buying aggressively over this past
week. Between our acclaimed monthly and weekly newsletters,
we’ve added 9 new stock trades and 2 new options trades this week alone! These include
high-potential-to-surge commodities stocks involved in developing and
extracting amazing oil, copper, molybdenum, rare-earths, gold, and silver
deposits. We just can’t pass up these wonderful bargains, and expect
these new trades to rally dramatically by next spring. And we have a lot more
buying left to do yet.
While it is
hard to buy into intense fear, the resulting gains are well worth the
challenge. Since 2001, all 591 stock trades
recommended in our newsletters have averaged annualized realized gains of
+51%! Can you imagine your capital growing at 50%+ a year? It’s awesome
beyond belief! So if you think you have the backbone to fight the crowd and
thrive as a contrarian speculator and/or investor, subscribe today to
our popular weekly or monthly newsletters! Don’t delay, as oversold
buying ops are fleeting.
The bottom line is the stock markets plunged to very oversold levels this week, resulting in fear surging.
Whenever such intense selling events happen in the stock markets, they mark
major interim bottoms. Oversoldness and excessive
fear are never sustainable, regardless of current or near-future newsflow. And the subsequent rallies out of these
oversold lows are big, fast, and highly-profitable.
It’s hard psychologically to fight the crowd
and buy stocks when everyone fears the markets are ready to charge off a
cliff. But it is exactly these fears that drive stock prices down to some of
their best entry levels ever seen in an ongoing bull market. So if you can
trade like a contrarian, be brave when others are afraid, the resulting
realized gains are massive. Carpe diem, buy low now in this major stock
So how can you
profit from this information? We publish an acclaimed monthly
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comments, or flames? Fire away at email@example.com.
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