Keep market ups and downs in perspective

Focus on your long-term goals to get through short-term volatility.

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Key takeaways

  • After bullish speculators pushed tech stocks into overbought territory, the stock market tumbled 5% last week.
  • In June, the S&P 500 Index fell 8% in a few weeks before advancing again. A similar consolidation now could be good for markets—within limits.
  • The important thing to keep in mind is that drawdowns of 5% are extremely common.
  • The best way to get through them is by sticking with your investment plan and avoiding attempts at market timing.

Every so often it is time to shake the tree, so that the weak hands get flushed out and the market can reset itself for a more sustainable advance. After an impressive 64% run off the March low, we were due for last week's flush.

The first momentum peak happened on June 8, and was widely credited as a buying climax driven by the retail day traders. Let's call that the day traders' top. That peak was followed by an 8% correction lasting a few weeks, until the advance resumed.

Then last week we had what I guess we could call the "FANG* peak," as this one is being blamed on a massive call buying spree in the FANG stocks intended to boost long positions in the underlying stocks. Call buying causes hedging demand in the underlying stock, so momentum begets momentum, until the whole thing runs out of gas and a correction results.

This peak produced only a 21% reading in terms of overbought momentum—compared to 44% back in June. That makes sense, since the gains were far more concentrated this time around.

So far, the reversal last week has produced a 5% decline amid an increase in volatility (as tends to happen during sharp declines).

Sentiment extreme?

A sentiment extreme is being blamed for last week's reversal, and while I think sentiment has certainly gotten more frothy recently, I still don't see a widespread signal that investors and traders alike are "all in."

The Investors Intelligence (II) survey, which polls newsletter writers, is probably the most lopsided sentiment indicator right now, with 62% bulls and only 16% bears. That % bulls level is in line with the kind of readings we have seen at previous tops.

But offsetting the II survey is the AAII survey (American Association of Individual Investors). This one tends to skew to older retail investors, and it continues to show a rather guarded sentiment toward stocks. As of last week, the bulls were at 31% and the bears at 42%.

Finally, industrywide, fund flows remain pretty neutral, and while some investors have been redeeming money market funds, it has not been of the magnitude that would suggest that investors are stampeding into risk assets.

What's next?

So where does this leave things for the market? With both the FANGs and the precious metals in correction mode, and deep cyclicals like energy and financials still lagging far behind, there isn't much that is taking over the leadership in the market.

That suggests to me that we are entering a period like June, in which the market corrects and consolidates while it clears the slate from excessive optimism. As mentioned, back in June the S&P 500 corrected 8% in the span of a few weeks. That was enough to cleanse the palette before resuming the advance. I think something similar would be a good thing for the markets here, provided that it doesn't do too much chart damage.

The chart below shows the percentage of stocks above their 20-day moving average. We are at 48%, down from 80% last week and 89% a few weeks ago. Back in June it took a move down to 13% before the market was ready to resume its uptrend.

The (opportunity) cost of market timing

An important thing to keep in mind as we digest last week's reversal is that 5% declines happen literally all the time. They may not be as strong and sudden as last week's decline was, but they are extremely common. The chart below shows a daily chart of drawdowns. As you can see, any decline less than 10% is often noise.

In fact, the chart below shows the percentage of time that the S&P 500 has spent at various degrees of drawdown. This is a daily time series going back to 1900 (that's a lot of Excel rows). Note that the market has spent 64% of its time in a drawdown of up to 5%.

Finally, while it's always tempting to try to trade around these corrections, remember that for most of us (and that definitely includes me), market timing often does the opposite of what it is intended to do. That is, rather than boost returns, they take away from investors' potential long-term performance, while also adding tracking error.

Below is a back-of-the-envelope attempt to quantify the effects of market timing. It is far from a perfect approach, but what I have done here is calculate the 10-year profit and loss (P&L) of all monthly net flows into equity mutual funds and ETFs, and compared that to the 10-year P&L of a dollar cost averaging strategy. Both of these are then compared to the long-term compound annual growth rate (CAGR) for both the S&P 500 and cash.

As you can see, while dollar cost averaging comes very close to replicating a buy and hold strategy (represented by the long-term CAGR of the S&P 500), fund flows (as a proxy for market timing) lag far behind and are pretty close to what you can earn by sitting in cash. Market timing, on aggregate, tends to detract from performance while increasing volatility. As my Fidelity colleague, Peter Lynch, has famously said, more money has been lost from anticipating corrections than from the corrections themselves. Word.

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