Often Times, Market Corrections are Just a Matter of Time

The Investment Update sent to you earlier this week showed how the behaviour
of investors can signal market bottoms. A key reversal day occurred on Monday
when stock markets dropped sharply (close to 3%) and then reversed on a dime
to close at the end of the day with a small gain. Many analysts and investors
continue to look at news reports, current issues and events in order to try to
determine what stock prices might do in the future. However, if you look at the
news flow early in the week, there was nothing to explain why buyers would all of
a sudden overwhelm the markets with buy orders on Monday and Tuesday.

 

What happened early this week is just one more piece of evidence verifying
that it is more important to observe how investors are reacting to all of the news
than to understand all the news investors are facing. We might think we can read
people’s minds to determine how they will respond to current events. However,
the facts show that market experts who study what is happening around us all day
long are wrong in their forecasts more than they are right. Why is this the case? It
is because neither we nor others have the ability to figure out how others will
respond to different factors. We tend to think everyone else thinks like we do and
that they will react exactly like we do. As I have said before, I cannot even figure
out how my wife is going to react to certain things after decades of being married
to her. If that is the case, how should I think I can determine exactly how the
masses will react? I cannot accurately determine how others will react by looking
at current events and history shows the experts cannot either. If that is the case, do
you think it is worthwhile for you to attempt to do it?

 

I have learned that it is better to focus on how investors are actually reacting in
the marketplace with their hard earned money. What happens in the markets is the
verdict of all investors after assessing the current situation, just like an election
shows the opinion of the electorate. As is the case with the stock markets,
pollsters can try to determine how people will vote in an election and we can too.
However, pollsters have been totally wrong in many cases recently. Why? Very
simply, people do not always respond in a rational way. Emotions are a major
factor in how we will respond and it is very difficult for anyone to assess how
others are feeling at the moment.

 

The pundits are telling us that rising interest rates are the reason for the
correction stock prices have been experiencing. True, the Fed and the Bank of
Canada have made statements about interest rates this week. However, often
market corrections occur just because prices have risen for too long.

 

In my book, Mind, Money & Markets, I explain that market trends are like
swimmers at a beach on a warm summer day. There are many who are sunbathing
on the beach and there is a wharf anchored out in the deeper water. When some
get hot or bored, they decide to swim to the wharf to cool off and have a change

of scenery. When others see this, they think that is a very good idea, so they swim
to the wharf and sit on the edge, dangling their feet in the water, enjoying a
different view. This seems attractive to those on the beach. As time goes on even
more swim to the wharf. Eventually, the wharf gets crowded and busy and one
corner may even become submerged in the water with too many people on it. This
causes those who came there first to swim back to the beach because they have
had enough. Others then start feeling the same way and eventually the wharf is
empty again.

 

Markets start to rise off a low when those who are disciplined and are able to
ignore their emotions take advantage of market weakness by investing their
money. As prices continue to rise off of the lows, other investors become more
confident and do some buying as well. This attracts more investors. As time goes
on and prices continue to advance, those who lack confidence finally feel a little
more comfortable and invest their money as well. When this has gone on too long
and perhaps prices have risen a little too high, traders who invested early in the
uptrend decide to take some profits. Buying eventually subsides as everyone who
wants to invest has done so and other investors don’t want to pay such high prices.
This is when prices fall and correct until they reach attractive values again.

 

If we look at the most recent chart from Investors Intelligence from January
25, 2022, on the next page, we can see that markets have been in a strong uptrend
since the end of March 2020.

 

 

If we look at the green line, which is a four-year chart of the S&P 500, we can
see that there have been many short, minor dips over the last 22 months.
Nevertheless, it has been a long uptrend. The black line shows the level of
optimism. You can see that there were 40% more optimists than pessimists in
September 2020. This was five months after the March 2020 low caused by Covid-
19 and the global economic shutdown that followed. By the end of 2020 and into
the first six months of 2021, the level of optimism reached the 45% level. This
implied that there was too much optimism and that prices might be getting a little
ahead of themselves. This would be just like when too many people were sitting on
the wharf to the point that is started sinking. Prices were not as attractive anymore.

 

You might ask, why not sell as soon as sentiment reaches the 45% level? If you
look at the S&P 500, you will notice that the level today is still much higher than it
was at the end of 2020 when it first reached the 45% level. This is even after the
recent correction.

 

It is always much harder to determine when to sell than when to buy. If we look
back at the last four years we can see it is very clear that it is prudent to buy when
optimism starts to rise after being around the 0% mark. The level of optimism was
14.8% last week and is at 8.2% this week. While some might feel that the risk of
further declines is increasing, Investors Intelligence suggests that is not the case.
Investors Intelligence states, “It signals diminished lower levels of risk and
selective trading opportunities.” Investors Intelligence states that a strong buy will
be triggered when optimism falls to 0% or into negative territory.

 

 

Often corrections like this just occur because an uptrend has carried on too
long or prices have risen too high. Although corrections can be correlated with
various events or developments, they may not be the actual reason stock prices are
declining. This also means that markets can recover before the issues facing the
economy are resolved. All that really matters is that the level of optimism falls to
a very low level once again. Once that happens, markets can get back onto a solid
foundation, which can enable a new uptrend to start. Once again, investors who
are only looking at the news feed, waiting for inflation to subside or omicron to
wane, are missing the point. They do not understand how markets actually
function. The key reversals that happened this week and the fall in the level of
optimism both point to lower risk and greater potential that a new uptrend could
start soon.

 

While the major market averages have only declined close to the 10% range,
certain sectors of stocks have been ravaged. The Russell 3000 Index is made up of
small companies. The average stock in that Index is down 35% from the highs.
The average stock in the NASDAQ, which includes many growth companies, is
down 50%. The reason the NASDAQ is only down 13% or so is because the
larger companies make up a much larger portion of the Index than the average or
smaller sized firms do. Small companies have seen their valuations wash out to
where they were 20 years ago. The Biotech sector has seen the greatest
underperformance compared to the market on record. In other words, there has
been a washout in the prices of most of the companies trading on the US stock
exchanges.

 

Perhaps because interest rates are so low and the risk is not high, this time,
traders and short-term investors who wanted to reduce risk moved out of smaller
and average sized companies and into the larger companies instead of moving into
cash. At this time, the valuations of smaller companies have been fully
compressed like a spring that is pushed together as far as it can go. Therefore
these companies appear to have the most upside potential. Please see the charts on
the next page.

Please see the chart of the Russell Index of 3000 small companies below. Even
this Index does not show how much the average stock of small companies has
declined over recent months. The reason for this is because the larger, more
prominent companies in these market averages carry much more weight than the
average or less significant companies do. (Charts are from WSJ)

 

The value of the innovative companies in the ARK Innovation ETF has declined
from $160 in February 2020 to $68 today, down 57%. This is a more realistic
illustration of what has happened to many smaller companies recently.

 

 

The chart below shows the trading action of the S&P 500 this week. After
many weeks of declining, prices appear to have stabilized this week even though
it was very volatile. Heavy selling on Monday and Tuesday morning were met
with heavy buying later in the day so key reversal days like this are signs that
buyers are now willing to step in any time there is weakness at these prices.
Markets bottom when there are more buyers than sellers, often in advance of
better news.

 

 

A sign that markets and sentiment have reached an extreme level either way
often occurs when magazine covers reflect what investors are feeling. The cover
of Bloomberg Business Week has a photo of a bull lying down covered in snow
with the caption, “Investors are bracing for more pain as a cold snap descends on
the market.” This is another positive sign. Please see a snapshot of the cover
below. Have a good weekend my friends!