Market Psychology Blog v2

Despite a Two-Year Global Market Selloff, US Equities Had Been Resilient

For the past two years we have been warning that investment markets were overvalued and at some point would need to correct.

The first to fall were commodities and emerging markets, which began a long and painful 15-40% decline nearly 18 months ago through today.

European markets next followed suit, beginning their declines in mid-2014, and now down 20% from peaks as well.

The main standouts were US equities, which continued to power upwards with very minor setbacks along the way. Every minor dip in the US was accompanied by a “buy-the-dip” mentality, which was rewarded time and time again.

A Changing Market Psychology with US Equities Joining the Rout

When it comes to the majority of successful investors, most are either driven by valuation indicators or by technical patterns.

Those that prescribe to value investing look to invest when assets are historically cheap, and to unload when they are deemed expensive.  With US equities nearly 60-70% overvalued in recent years, value investors have moved out of the market and more heavily into cash.

Technical investors use momentum as their guide, trying to ride the major trend, while getting off the wave when it changes…and oftentimes trying to ride the trend in the other direction as well once the trend reverses.  Technical investors are not afraid to go both long and short the market.

While value investors have been absent in US equity markets, technicians have continued to play the uptrend, pushing markets to subsequently higher and higher peaks. With each minor setback to support levels, technicians would “buy-the-dip” and drive the market to ever higher peaks.

This strategy has repeatedly worked, emboldening the technicians while frustrating value investors who have watched the markets rise from overvalued to absurd.

However, with our most recent decline, major technical support was taken out to the downside as can be seen in the chart below:

Buy the Dip Blog Post

S&P 500 With Technical Support Trend Lines for Past Two Years

After seven successful buy-the-dip instances over the past two years, dip-buyers were significantly harmed during this go-around, and subsequently the market sold off sharply.

With the critical 350-day moving average support line breached, the three main market participants are positioned as follows:

  1. Value investors still believe the market is 50-60% overvalued and are not playing
  2. Technicians, who now believe that we are in a downtrend, will short the market on any bounces higher
  3. Everyone else who was long the market is praying that it will come roaring back

Nobody can predict what will happen in the days and weeks ahead, but history points to #1, and #2 above being the “smart money,” while #3 is everyone else.

LGA Outlook & Portfolio Positioning

At LGA , we are value investors who use technical analysis to help gauge how much risk on / risk off we should have in our portfolios near term.

From a valuation perspective, we have been defensive in our tactical client portfolios, which has allowed us to weather major global declines nicely.

Technically, we also believe a lot of damage was done in recent weeks.

With daily trading sentiment at extremely oversold levels, we expected a bounce off of market lows, as expressed in our recent mini client update email last week.

However, we expect this bounce higher will prove fleeting, with technicians re-shorting the market as long as it stays below the critical 350-day moving average.

With technicians neutral-to-bearish right now, and valuations are far from low enough for value investors to start jumping in, all that remains are emotionally driven traders that are hoping their “buy-the-dip” proves to work yet again.

We don’t discount the fact that it possibly could work again this time.  However, our indicators suggest we are looking at something different with this recent decline, and that the higher probability is for further downside.

We will keep a close eye on the situation and continue to position client portfolios extremely conservatively.  For example, our volatility hedges have surged in recent days, and we would expect that any further market declines would result in these hedges absolutely skyrocketing…delivering on the insurance policy we have purchased during the last 18 months.

A client recently asked, “Should I be worried about the market dropping?”

My response to her was that she should not only stop worrying, but could actually cheer for it to decline in the least humanly-tragic way possible, as her portfolio would not only survive but thrive…and we would be left with the opportunity to pick up assets on the cheap.

While we are waiting for this wonderful buying opportunity, our accredited clients continue to collect income checks from our recession-resilient private opportunities (fyi – we are releasing a quarterly update on this program tomorrow).  For our non-accredited clients, we continue to protect your portfolios with cash and market-neutral funds, generate some returns with our hedges, and patiently await the coming opportunity to put your money to work.