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Last Updated on: 23rd February 2016, 02:42 pm
In light of recent market turbulence, one question investors might naturally be thinking about is how concerned should they be? Before answering, it is worth considering two things that old Wall Street hands try to keep in mind.
The first is the fact that the investing “crowd” may not be right. That is especially true at major inflection points, when there is often widespread confidence, bordering on faith, about why a bull or bear trend will continue. During those times, even the man (or woman) on the street knows the various rationales, and they are quick to offer an opinion, often unsolicited, about what happens next.
Indeed, if a trend becomes popular enough for the mainstream media to take notice, that can be a good sign that it is reaching a peak. Originally proposed by by analyst Paul Macrae Montgomery, the “magazine cover indicator” holds that when a business or financial trend has been in effect for a sustained period of time, and those who would not normally care about it are clamoring to know more, that suggests there aren't enough greater fools left to keep momentum going.
Some classic examples of this theory in action include the June 2005 Time cover story on the U.S. housing market, which effectively marked the peak of the real estate boom; a March 2005 front page Newsweek article on “The Incredible Shrinking Dollar,” which preceded a violent reversal in the U.S. currency; and a New York Times Magazine feature about gold, which virtually coincided with the start of a major correction.
Another thing that seasoned market-watchers try not to forget is how dangerous it can be to think that “this time is different.” Not surprisingly, that phrase has often been the rationale for sticking with trends well beyond their sell-by-dates. Perhaps the most famous example of this particular maxim in action occurred just before the 1929 crash, when the well-regarded economist Irving Fisher said that “stock prices had reached what looks like a permanently high plateau.” Such sentiments were also apparent before the 2007-2009 financial crisis struck, when experts and novices alike predicted that such a catastrophe could not happen.
Again, the lesson here is that when it is said that the old rules no longer apply because we are smarter, richer or more experienced than in the past, it is often a sign of trouble ahead.
With such perspectives in mind, what is one to make of the fact that many think conditions have reached a danger point? Citing a survey by the CFA Institute, the Wall Street Journal recently noted that investors believe “another full-blown financial crisis is due in the next three years,” with retail investors being “the most afraid.” The article also highlighted a survey by Bank of America Merrill Lynch that showed “funds now hold more cash as a percentage of their portfolios than at any time since 2001.”
The knee-jerk contrarian reaction is to assume that the “crowd” is too bearish and now is the time to buy risky securities and dump defensive holdings, including safe haven assets such as gold. Maybe that is right–nobody knows for sure, of course–but it also raises the question of whether such sentiment marks the beginning of a full-fledged reversal of fortunes or a temporary squall that needs time to dissipate.
One reason why the latter may be closer to the mark has nothing to do, by the way, with any suggestion that things are different this time. Rather, it stems from the historical reality that markets generally don't move in a straight line. The fact that such concerns have surfaced after equities, in particular, have experienced a modest pullback by historical standards suggests we are in the midst of a corrective lull, not a return to the good old risk-on days.
In other words, it doesn't seem contradictory to say, as I did in “Bad News is Good News for Oil Prices?” that bearishness towards crude oil, which has shed nearly two-thirds of its value over the past 16 months, has reached a contrarian extreme, while concerns that largely stem from this year's 6% share-price stumble, has not. As noted above, bearish mood shifts are most meaningful when they come on the heels of a dramatic downtrend.
Still, the fact that the attitudes of some have soured so quickly is probably another reason to consider, as suggested in “What's Next for Gold?” waiting for a better entry point to boost holdings of precious metals. Moreover, for those who concluded, like I did in “The U.S. Stock Market Is Set for a Fall,” that equities are heading lower, it may be worth waiting for better levels to sell or go short.