With the market 25% below its peak, the time to sell may be over but it does not mean that it's time ... [+]
There are serious arguments against buying stocks now, even with the S&P 500 25% below its peak. But is selling a good strategy? It depends on how much further the market could fall. Market history suggests that much lower levels are possible, but the real issue is how long the market stayed at those levels before bouncing back. Understanding what drives the market and how investors behave could be helpful in deciding what to do next.
The S&P 500 broke through the June lows and it looks like it’s heading lower. No wonder, since the Fed has made clear that it will keep tightening policy for the foreseeable future and accepts a recession as a fair price for lower inflation. Earnings projections have been slashed accordingly and stocks are falling.
The Fed will need to revise its plan if the widely-expected recession starts looking “severe” rather than “mild.” Or if the Fed’s “quantitative tightening” – a fancy phrase for reducing the supply of money – ends up causing a financial accident. Think of a corporation that finds itself unable to roll over maturing debt. Or, worse, a bond mutual fund that has trouble meeting redemptions because it can’t find buyers for the bonds it needs to sell.
These are not idle speculations. Some of that is unfolding in the UK at this moment. The Bank of England is intervening daily in emergency bond-buying operations to shore up the market. Some think this is the canary in the coalmine.
It is clear, therefore, that there are more urgent matters than the minutiae of economic indicators or the dissection of earnings announcements. The market is getting nervous and can be easily spooked. This is how crashes happen.
The current bear market is unfolding just like prior ones. The pattern is simple: After an initial fall from the peak, a strong recovery follows but it fizzles out, and the market declines to a lower point. From there it recovers again, but fails to reach the highs of the previous bounce and then falls well past prior bottoms to a final trough. That final leg is often the sharpest and happens in a panicky fashion.
If we are in that final phase, how much more could the market fall? Prior bear markets ended with levels anywhere between 27% and 57% below the initial peak.
The stock market is entering a final phase of a bear market. Prior declines stopped around today's ... [+]
The good news
The extreme sell-offs of the past were short-lived, so it makes sense to expect that the next one (when and if it happens) will be short-lived as well. The troughs were also the points where new bull markets started.
The 57% decline of March 2009, for example, lasted a couple of days, and two weeks later the S&P 500 was 24% higher. Likewise, after the 49% decline of October 2002 the index was 19% higher by November. The bull markets that followed lasted years.
Why would a crash give way to a rally? It sounds counterintuitive, but here is a plausible explanation: As long as investors have unrealized losses (as they do now), they don’t want to add to losing positions, so buying dries up. Fewer buyers mean stalling prices. A market that goes nowhere prolongs uncertainty and provides fertile ground for an external event to spark a wave of selling. When that happens, prices fall rapidly, the market crashes and the last to sell end up locking in the worst losses.
That’s when the nimble few start buying at the bottom, establishing a very low cost basis. As such, they have no urgency to sell. Additional buyers, finding few offers at the lower prices, start bidding the market up. From there, cautious buyers pay even higher prices, and a virtuous cycle takes hold – all based on the extreme realized losses and the lower cost basis of the newest positions.
What to do
There are two lessons here. First, the final decline happens while investors succumb to panic and when many of them sell around the very bottom – the worst possible point. Therefore, the first lesson is to remain calm if and when the market crashes. It will overshoot, and that extreme weakness will likely be short-lived.
Second, precisely because the market goes way past a reasonable bottom that is over quickly, it is very hard to buy at that extreme low. This is because the bottom is only known after the fact and it doesn’t sit there for long. Still, the lesson is that those who remain calm will have a good opportunity to buy the market on the cheap, even if they miss the lowest possible price.
That is easier said than done. The trauma of the crash will be still quite fresh, and many will find it difficult to act when emotions and opportunities are running in opposite directions. This is why investing is hard.
Should you buy now, 25% below the peak? Considering all the hurdles ahead and the fact that a capitulation has not yet materialized, it seems premature to buy at these levels. Should you sell, then? Conversely, it may be too late to liquidate your portfolio here – but then again, it could save you another 25% on the downside. This is what nobody knows.
Chances are that if you are still fully invested, you are not the type of market player that would be able to sell now and buy quickly once the market bottoms out. That is not to say that you should just sit there while (or if) the market crumbles around you. But selling indiscriminately now may not be your best course of action.
What if a capitulation never comes? In that case, it is unlikely that the market will run away from you and you will have time to rebuild positions or see your existing ones regain value. Patience, in that case, will be the winning virtue.
More than ever, you need to consult your financial advisor who understands how you approach risk and seek his or her advice to identify which assets to sell and which to keep, or whether it’s best to hedge existing positions with an inverse ETF like SH or PSQ
