The Psychology Of Volatility

MAKE IT STOP

Nobody likes minus signs and red screens, which create a feeling of being out of control. While hitting a sell button can make us feel like we are back in control, it often leads to overtrading and disappointing returns.

RECENT EXAMPLES

The chart of the S&P 500 below shows a period with several red days that featured strong selling pressure. Red screens and minus signs were unnerving during period A, just as they have been unnerving over the past week.

Period B below most likely featured numerous examples of overtrading and swigs of Pepto-Bismol.

We all wake up every day with limited amounts of mental and emotional capital. Staring at red screens and counting up your losses during period C below would have been an energy-sapping task.

WHAT HAPPENED NEXT?

Despite numerous scary red days, between point E and point F the S&P 500 gained 11.59%.

HARD DATA HELPS WITH ODDS

If we add the S&P 500’s 200-day moving average to the equation, it becomes more apparent that periods A, B, and C all occurred within the context of an existing uptrend. Since uptrends make higher highs by definition, the slope of the 200-day told us to remain open to good things happening once the period of volatility ended.

There is nothing magical about the slope of the 200-day moving average; it is shown as a proxy for the weight of the evidence that existed in calendar year 2017. No indicator, including the 200-day, should be used in isolation to make any decisions related to the health of the financial markets.

HOW DOES THE 200-DAY LOOK TODAY?

Given what we know today, the weight of the evidence continues to favor the “we are still in a bull market” side of the ledger relative to the “the final high has been made” side.

BROADER EVIDENCE COVERED HERE

This week’s video revisits numerous forms of hard evidence that was used to make the bullish case over the past 2+ years. Is the evidence starting to deteriorate in a meaningful way? You can decide after viewing charts of the S&P 500, NASDAQ, Dow, small caps, global stocks, and bonds.

DAY BY DAY

If the weight of the evidence shifts in the coming days, weeks, and months, we must remain flexible enough to reassess the odds of good things happening relative to the odds of bad things happening.

The Market's Tell

INVESTOR CONVICTION

When markets peak, it speaks to a changing of the guard. During the bullish phase, the conviction to own growth-oriented stocks is greater than the conviction to own defensive-oriented bonds. During the bearish phase, the conviction to own defensive-oriented bonds is greater than the conviction to own growth-oriented stocks. The stock/bond ratio (see chart below) peaked several months before the major stock market peak that occurred in October 2007. The blue 100-day moving average helps us visualize the changing of the guard.

A NEW GUARD IN TOWN?

Thus, if the January 26, 2018 peak in the stock market was part of a major-topping process, we would expect to see the conviction to own defensive-oriented ETFs increase relative to the conviction to own growth-oriented ETFs, which is not the case as of September 10. We could have made the same argument using numerous risk-on/risk-off ratios.  Broad asset class behavior continues to side with the bullish case.  

A STRONG VISUAL STATEMENT

If we remove volatile price from the equation and focus solely on the stock/bond trend, we see a stark contrast between investor conviction in 2007-08 and 2017-18.

SIMPLE AND POWERFUL CHARTS

This week’s stock market video uses six simple charts to illustrate important concepts about investing, risk, and asset allocation. Comments from viewers include “must watch”, “only video you need to watch ”, and “excellent video”.

CHARTS HELP US ASSESS ODDS

Present-day charts tell us to remain open to better than expected stock market outcomes. If the charts deteriorate in a meaningful way, we must be flexible enough to reassess the odds of good things happening relative to the odds of bad things happening. We will continue to take it day by day.