KEY REVERSAL DAY TODAY SUGGESTS CORRECTION COULD BE OVER
We tend to think that business and investment decisions are made on a
purely rational basis. Nothing could be farther from the truth! Our emotions are
very powerful and they affect everything we do from making investment
decisions to what we are going to wear each day and what we will eat or drink.
Ever since markets began, prices have been impacted by varying levels of
optimism and pessimism, just like economies have had booms and busts. Stock
prices rise when there are more buyers than sellers and fall when there are more
sellers than buyers. Most investors and portfolio managers hold on to positions for
some time so most of the daily volatility that markets experience is caused by a
very small percentage of investors.
We must always remember that stocks are appraised every business day for
what they are worth in exchange for instant cash. This is because they can be sold
or purchased every business day. Some avoid stocks since they say they are
volatile. Keep in mind, if you had your home, vehicle or business appraised for
what it would be worth for instant cash every day, I venture to say you would see
exactly the same volatility. For example, if you had a nice BMW convertible and
you wanted to sell it for cash on one of the recent days when we had a major
snowfall or freezing rain, how much do you think you would get for it? You
would probably be able to sell it for much less than you could on a sunny, warm
day in spring. So, what is that vehicle really worth? What something is worth
depends on the conditions at the time. If you choose to sell something when
people are not in the mood to buy, the selling price will be less than when people
are in the mood to either spend some money or buy the product they want.
Interest rates have been at extremely low levels for some time, which has
enabled stock prices to produce attractive returns in 2020 and 2021. A stronger
economy and rising inflation means there is now pressure to raise interest rates.
As interest rates rise, every other investment becomes a little less attractive. This
has put investors in a negative mood. So, rising rates can have a negative affect on
the value of stocks. However, in the past, the economy and stock market have
usually continued to thrive until short-term interest rates rise so much that they are
higher than longer-term rates. Today, the interest rate on a 3-month Treasury Bill
is 0.18% while the yield on a 10-year US bond is 1.43%. If history repeats, this
means short-term US interest rates would have to rise more than 1.25% in order
for the yield curve to invert. Usually stock prices and the economy even continue
to grow for some time after short-term rates are higher than 10-year bonds before
faltering. In other words, the prospect of rising interest rates is causing some
uncertainty at this time, but rising interest rates are unlikely to cause problems in
the economy and stock markets for some time.
Either way, stock prices don’t go straight up. Corrections of 4% to 7% can
occur two or three times a year. A 10% correction once or twice a year is as
common as a major snowfall in the Fraser Valley. We don’t think of building an
ark every time we get severe rainstorms. In the same way, becoming concerned
that stock prices might fall every time there is a setback is a waste of time and
mental energy.
I have experienced so many dips, corrections and bear markets that have
concerned investors over my career. Yet, in spite of them all, the Dow Jones
Industrial Average has increased in value by 36 times from 1,000 to 36,000, from
1980 to this year, not including 160 dividends that were paid out to investors
every quarter. The question investors have to ask themselves is this – how
useful has it been to become concerned about falling stock prices every time
there is a decline? At times like this, a saying from legendary mutual fund
manager Peter Lynch comes to mind. He said, “The real key to making money
in stocks is not to get scared out of them.” It is simple but profound!
Of course, rising interest rates are not the only concern facing investors and
business owners right now. The wave of the omicron variant, business shutdowns,
a shortage of workers because so many are ill and the resulting disruptions in the
supply chain is also causing uncertainty. Investors detest uncertainty. Disruptions
in supply chains are also one of the chief reasons that inflation has been rising so
much. There are many reports that the omicron wave could be peaking in Canada
and the US in the coming weeks. If that happens, it could have a profound impact
on the economy and inflation over time. This could also remove much of the
uncertainty that investors are dealing with now and improve the mood of
investors.
Data from Investors Intelligence shows that optimism has only been this low
two other times in the last four years. Please see the chart on the next page.
The green chart (from January 18, 2022, which does not reflect the decline in
prices or optimism over the last week) shows the US S&P 500 Index going back
to early 2018. The chart with the black line shows the level of optimism over the
same period. You can see that optimism increases when stock prices rise and falls
when stock market decline. This shows very clearly that buying when we feel
optimistic and selling when we feel pessimistic is not the way to be a successful
investor!
You can see that optimism has only been this low when prices were on their
way to falling 20% in December 2018 and when prices were on there way to
falling 35% in March 2020. A major takeaway from this chart is that the S&P 500
Index has experienced a major uptrend over this four year period in spite of the
shocks caused first from an error by the Fed in raising interest rates too much in
late 2018 and secondly when Covid 19 swept over the world in early 2020. Over
this long-term uptrend there have been dips that are too numerous to count.
The common pattern for stock prices is to take three steps forward and then
one back. Often buying can get carried away, which can move prices higher than
they should be. Higher prices then hold back buyers and increase selling in the
short-term. Often the selling can get carried away on the downside as well. While
stock prices usually roll over slowly at a market top, market bottoms are often a
violent affair. People react out of fear to preserve their wealth much faster than
they do out of the desire to increase their wealth. Consequently, selling can beget
more selling, which can cause prices to cascade lower. This is what was
happening last week. At a time like this, I am looking for signs that the selling has
reached a climax. For when everyone who wants to sell has sold, prices cannot
fall anymore. We must also accept the fact that stocks actually become more
attractive as prices fall. (I have found it interesting that shoppers will flock to
store or gas station when there is a 10% discount, but will seemingly line up to
sell stocks when they are selling at a 10% discount. Humans are not rational!)
Most market bottoms occur early in the week on a Monday or Tuesday after
markets have been falling the week before. Some investors get their shorts all tied
up in a knot when they have all weekend to look at what has happened to their
portfolio value in the previous days. When Monday arrives they cannot help
themselves from succumbing to the temptation to bale and sell their investments.
Typically, there is a day where prices fall sharply as the selling snowballs and
then prices turnaround and jump higher just as quickly later in the day. This is
called a key reversal day. It is a classic sign that usually appears to show investors
that the selling has reached its climax and that buyers are once again taking over
to take advantage of attractive prices. This is how Stockcharts describes a key
reversal day. “It is a one-day pattern where prices sharply reverse during a trend.
In an uptrend, prices open to a new high and then close below the previous day’s
closing price. In a downtrend, prices open lower and then close higher. The wider
the price range on the key reversal day and the heavier the volume, the greater the
odds that a reversal is taking place.”
Today, major US market averages fell close to 3% half way through the
trading day and then reversed sharply to close with a gain. Today, human
behaviour in the markets once again followed the classic pattern that has
determined many market bottoms in the past. We must never forget that the
conditions around us are always a little different. However, the one factor that has
not changed in thousands of year is human nature. If we forget about the news and
just focus on these classic patterns of human behaviour, I believe it is the best way
to really understand what is happening in the markets. Please see the one-day
chart of the Dow Jones Industrial Average for today on the following page. (From
WSJ)
You can see that the DJIA opened today well below the close on Friday
(marked by the red line) and then continued to fall to where it was down more
than 1,100 points or close to 3% by mid-day. Then, all of a sudden, with no news,
the trend turned around in an instant and reversed, recovering all of the losses for
the day and then some, to close up 0.29% or 99 points for the day. This meets all
of the criteria for a key reversal day. Market action over the rest of the week
should confirm whether this price action will actually mark the low point for this
correction. I will continue to keep you informed as time goes on. Thank you for
your trust and confidence!
I have gone for a 9 km run with a 1,000 foot or 330 metre vertical climb near
my home almost every three days for more than 20 years now. This provides time
for reflection, relief from any stress and keeps me in good physical and mental
condition.
The turnaround at the highest point is at the top of Mount Thom. The view
during my run at sunset today was quite beautiful after all the dreary days where
all you could see was clouds so I took this photo for you. It is looking to the west
with the Promontory area in the foreground and Sardis/Vedder area in the
background. Hope you have a great week my friend!
