The stock market is a master manipulator. It repeats a pattern over and over. Just when we are convinced of the pattern and think we have the market all figured out, it changes character.
For the past few years, I’ve been bullish and saying to stick to the trend for many reasons. One of those reasons has been psychology. Specifically, every time the market starts to pullback, many sentiment indicators spike to extreme fear levels, the selling stabilizes, and the market recovers back to new highs. This pattern has repeated itself at least 10-12 times over the past few years.
For example, during the second half of June 2018, the S&P 500 started to decline to its 50-day moving average and it seemed like a normal pullback in my view. What shocked me was the incredible escalation in fear recorded by several sentiment measures such as the CBOE put/call ratio, the AAII Sentiment Survey, and the NAAIM active manager survey. Sure enough, the market stabilized shortly after this pullback and resumed its move to new highs. I’ve always felt that the market would finally correct when this pattern stops and I noticed that it did over the past few weeks.
In early October 2018, the S&P 500 had another normal pullback to its 50-day moving average but this time sentiment measures were showing little fear. Meanwhile, I got stopped out of most of my positions because even though the index was only 1.9% off its highs by October 9th, the average stock was 13% off its highs. I moved my clients to a very high cash position because I figured it was only a matter of time before the averages caught up on the downside, especially because there was minimal fear showing up.
Here’s the part where the psychological pattern changed. The S&P 500 broke its 50-day and sliced quickly down to its 200-day in mid-October. Meanwhile, the various CBOE put/call ratios barely moved higher. I expected the NAAIM survey to drop but it actually ticked HIGHER last week! I started talking to some trader friends, who normally stop themselves out and raise cash, but many of them were very complacent and staying fully invested. A few of them talked about no longer using hedges because every time they did so in the past few years, they would just lose money and they were getting sick of it. I realize that talking to 20 or 30 people is a small sample size, but this was an incredible change of character in market psychology.
What really shocked me was today’s (October 24th) CBOE Equity Only put/call reading of 0.71. The Dow Jones dropped 600 points, the Nasdaq Composite cratered close to -4.5%, and still there’s not enough fear??? Normally on a brutal day like today, this reading should come in at 0.90 or higher. In addition, I still haven’t got the calls/texts from the usual friends and family asking why the market is declining. Don’t laugh because this is a very consistent contrarian indicator.
If I can offer any words of encouragement is that there will be another strong uptrend in the stock market but it will require some patience and discipline until it happens. Of course we will see some bounces and short covering rallies during this correction, but the one pattern that’s changed is the lack of fear that has normally occurred during previous pullbacks. Unfortunately, I still think we need to see this escalate before the market bottoms.
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