Adam Hamilton November 4, 2011 3100 Words
October was truly an epic month for the stock markets. The flagship S&P 500 stock index rocketed 10.8% higher! As its best month since December 1991 and best October since 1982ís, October 2011 was inarguably awesome. While it remains fresh in our minds, it is important to remember the psychology leading into it. Fearmongering ran rampant in late September, hyper-bearishness reigned supreme.
The stock markets are a huge business, with the best-and-brightest minds spending countless billions of dollars trying to game their near-future price action. With effectively unlimited resources thrown at research aimed at understanding the markets, wouldnít you think traders would have been very bullish heading into the stock marketsí best month in decades? Quite the opposite was true, they were terrified.
The reasons are legion. Septemberís 7.2% loss in the S&P 500 (SPX) was its worst month since May 2010. Towards the end of that ugly month, all kinds of fears abounded. Greece looked doomed, Europe looked like it was fracturing, China looked like its economy was slowing, and the US looked like it was nosing over into another recession. Everywhere one turned, all the news looked awfully bad.
With traders very scared and global newsflow seeming to justify their bearishness, fearmongers had a field day peddling their wares. A fearmonger is an analyst who traffics in fear, always bearish and always predicting an imminent panic or crash in the stock markets after any selloff. Since traders seek to rationalize their own fears whenever they are scared, fearmongering has grown into a lucrative cottage industry.
Most of the time fearmongers are rightfully ignored. After someone predicts an imminent panic or crash or new bear market or some other calamity for countless months in a row without being right, their credibility naturally erodes to zero. But during those relatively-rare times when very-weak stock markets lead to widespread fear, fearmongersí pessimistic theories enjoy surging popularity for a spell.
A great example happened in August 2010. The SPXís young cyclical-bull market had just weathered a major 16.0% correction, so fears ran high. Then an obscure fearmonger few had ever heard of started advancing a theory he flashily named the ďHindenburg OmenĒ. This complex set of technical conditions was supposed to portend a full-on stock-market crash, a 20% plunge in the SPX within a couple days!
Since traders were scared, this Hindenburg Omen thesis spread like wildfire. It was discussed in the Wall Street Journal, and the fearmonger who created it was interviewed on CNBC. All this publicity was no doubt very good for this manís market-research business! But the Hindenburg Omen was a garbage theory, it didnít work. It had triggered 25 confirmed signals since 1985, a period of time that only had a single crash (1987) and a single panic (2008). Successfully signaling 25 of the last 2 panics and crashes?!?
What really happened out of that fearmongering episode? Rather than crashing as widely feared, the SPX soared 30.2% higher in a strong cyclical-bull upleg between late August 2010 and late April 2011! Many of the commodities stocks we had bought at low prices during the fearmongering more than doubled over this span. Instead of being bearish, the fearmongers are so wrong their arrival is bullish.
Fast forward to the end of September 2011, just before the biggest monthly stock-market rally in decades. Fearmongers again enjoyed wide and receptive audiences to their bearish theories. Thanks to an erroneous US jobs report that was subsequently revised away, a leading economic think tank boldly called a new US recession on Septemberís final trading day. This helped batter the stock markets to a marginal new correction low on Octoberís opening trading day.
Was this recession call made right near major SPX lows correct? Not so youíd notice! At the end of October the US Commerce Department reported that US GDP surged at a +2.5% growth rate in Q3, its best performance in a year! Thatís a recession? In late September commodities and commodities stocks got crushed on another subsequently-revised-away report out of China suggesting its economy was slowing. But a few weeks later China reported stunning Q3 GDP growth of +9.1%! As always, the fearmongers were dead wrong.
I could write a book full of examples like these, of popular bearish calls made right near major stock-market lows by fearmongers. Having painstakingly chronicled the daily market action in great detail over the last decade or so in our popular subscription newsletters, I have detailed records and could name names. But my goal isnít to discredit fearmongers, they do that themselves. I want to help speculators and investors avoid fearmongeringís traps.
Everyone with capital deployed in the stock markets is there for one reason only. We all want to grow our hard-earned savings. No matter what your time horizon is, the only way to accomplish this mission is to buy low and sell high. And stock prices are only driven to exceptionally-low bargain prices when the great majority of traders are scared. This only happens after major stock-market selloffs, when fearmongers dominate popular discourse.
During these times of widespread anxiety and fear, fearmongering becomes extremely seductive psychologically. If you are scared, you think your emotions are totally righteous. So you naturally seek out people that share your beliefs, using their bearish theories to attempt to rationalize and justify your own decision to be scared. But if you fall under a fearmongerís sway, you are either going to sell low or fail to buy low. Both grievous errors will vastly reduce your long-term success as a speculator or investor.
Having started trading stocks in my own brokerage account my father opened for me when I was 12 years old, I am a lifelong speculator, investor, and student of the markets. Over the decades since Iíve learned much, making countless mistakes along the way but still amassing a fortune. One of the greatest lessons Iíve learned is that price action drives newsflow. Carefully parse this phrase out and think about it.
Most traders assume the markets work the other way, that newsflow drives price action. Stock markets fall because bad news leads traders to sell. Therefore the worse the news of the day looks, the more bearish the stock markets look. This seems logical of course, but it is completely untrue the vast majority of the time. The more stock markets fall, the more traders actively look for bad news to rationalize their fears.
On any given day in the markets, relative to our puny little human brains there is effectively-infinite information to process. While a few stories emerge to dominate that dayís discourse, there are literally dozens or hundreds of other material stories also happening that day. The financial media and traders choose to focus on good news when the markets are up, and bad news when they are down. The price action drives everyoneís selection bias in terms of what stories to deem important on any given day.
So after a selloff, newsflow goes negative as everyone attempts to justify the selling based on news. The bigger the selloff, the more pessimistic and bearish the selected newsflow looks. And by late September leading into Octoberís massive rally, the SPX had fallen precipitously to a very-large monthly loss. Europe looked to be fracturing over the tired Greek debt crisis, and economic growth in the US and China looked to be slowing. So speculators and investors alike sold aggressively, right into the low prices near the very bottom!
The temptation to sell into such lows on serious bearish newsflow is great, but you can avoid this deadly psychological trap with a couple simple tools. First, there are objective ways to infer overall fear in the stock markets. By using such indicators, you can know whether the fear is excessive and overdone or not. Second, you can learn to identify fearmongers in advance before their poor understanding of the stock markets helps convince you to sell low or not buy low and lose big money.
The perpetually-warring emotions of greed and fear, not newsflow, are what drive short-term stock-market price action. Traders gradually grow greedy in an upleg, with their greed reaching extremes after a big rally. At that point stock prices are overbought, meaning they rallied too far too fast to be sustainable. With the excessive greed already sucking in all traders interested in buying, only sellers are left. So the stock markets start selling off right when things look the most bullish and everyone is euphoric.
The subsequent correction rebalances sentiment, gradually replacing excessive greed with excessive fear. The longer a selloff persists and the deeper it goes, the more scared traders get. Eventually stock prices hit oversold levels, they have fallen too far too fast to be sustainable. The excessive fear scares everyone susceptible to it into selling, leaving only buyers. So the stock markets start rallying right when things look the most bearish and everyone is terrified. Like in early October!
The simplest way to get a read on the overall greed and fear in the stock markets is through the implied-volatility indexes. These classic fear gauges use complex formulas to distill stock-index-option trading activity into an effective expectation of near-future price volatility. Greed and fear are asymmetric emotions, the former builds slowly while the latter flares up rapidly. With fear a more-potent and immediate motivator, high volatility is a characteristic of fear-laden times. Greed witnesses low volatility.
The volatility indexes such as the S&P 500ís VIX, or my favorite for technical reasons the S&P 100ís VXO, reflect these volatility expectations and hence popular greed and fear. A low VXO indicates greed, warning the stock markets are likely overbought and due to correct. And a high VXO indicates fear, meaning that the stock markets are likely oversold and due to surge. Bearish theses advanced in times when the VXO is exceptionally high are fearmongering, plain and simple.
This chart superimposes the flagship SPX stock index over the VXO fear gauge since this current cyclical bull was born in March 2009. Note that VXO spikes accompany every major bottoming after both SPX pullbacks (less than 10% selloffs) and corrections (greater than 10%). The higher the VXO read after a selloff, the more major the bottoming and the more powerful the subsequent upleg is likely to be.
Iíve written about this chart extensively, both as a warning before the SPX corrected in mid-April and as a bullish buy signal after the SPX corrected in mid-August. So check out those previous essays if you want more depth. But for our purposes today, just realize that high VXO spikes mark major bottomings. Yet when the VXO is at those short-lived highs is exactly when fearmongers temporarily gain prominence.
Provocatively as I also explained in depth in August, stock fear as measured by the VXO has an effective ceiling. In normal market conditions excluding the ultra-rare once-in-a-generation panics and crashes, it is 50. Note above that both in early August and early October 2011 the VXO soared near this ceiling on an intraday basis. A VXO 50 read is the most-bullish buying signal ever seen, in bull and bear markets alike. It means fear has peaked.
On the last trading day of September as global recession fears scared excitable traders, the VXO closed at 44.2. Then on the first trading day of October it closed at 45.5. The next morning it soared as high as 49.2 intraday! You can see in this chart just how rare such high VXO levels have been. We hadnít seen anything like that since the secondary stock-panic lows in early 2009. Fear was absolutely extreme and excessive then, a perfect environment for fearmongering to thrive. At the very bottom!
So when the stock markets have sold off and the bearish newsflow is concerning you, look to the VXO or VIX before you decide what to do. The higher the VXO, the more important it is to totally disregard the fearmongering as simply a response to weak price action. The higher the VXO, the more scary stories gain prominence as traders try to rationalize their irrational fears. But near such SPX lows are the exact wrong times to be scared. It is always foolish to sell low into a high-fear environment as measured by the VXO!
Checking the VXO anytime is very easy, as you can just type its symbol (along with the appropriate index flag) into whatever financial website you use for your stock quotes. Whenever it gets into that 40-to-50 high-odds bottoming zone, you should be aggressively buying instead of selling as the fearmongers are arguing. The fear has grown so excessive that itís burning itself out, all the sellers have or will soon have already sold out. This leaves only buyers and helps fuel major rallies.
We had a ton of new commodities-stock trades on by the dawn of October that were just crushed in late Septemberís China-growth scare. We bought these stocks righteously at low prices in the previous couple monthsí bottoming process. But as I warned our subscribers heading into October, it was absolutely the wrong time to sell. We even held our noses and added more trades in the fear! And then all our trades rocketed in October, dramatically leveraging the SPX rally. One key reason I made this correct contrarian call then was the VXO was way too high, signaling a major bottoming despite the fearmongering.
In addition to not taking scary stories and bearishness seriously in a high-fear environment, identifying fearmongers is important. If speculators and investors know a fearmonger has a record of fearmongering near lows, then he has zero credibility. So next time someoneís bearish theses catch your attention in a high-VXO environment, all you have to do is check what they were saying at past known major lows. Were they very bearish in those times too, wrongly advising people to sell low near the very bottoms?
In the past couple years, weíve had several major lows in the SPXís post-panic cyclical bull. The first was in March 2009 as this bull was born, an exceedingly-scary time when it truly did look like the sky was falling. The second was in the summer of 2010 after this bullís first full-blown correction, and the third was recently in August and September 2011 after this bullís second correction. What did the person whose bearish theses are worrying you now say back then?
Thankfully in the Internet Age, this is really easy to find out. Many analysts write publicly, and newsletter writers generally have no problem sharing back issues with prospective subscribers. When you investigate what a fearmonger today was saying back at those known major lows, most of the time you will find they were advancing the exact-same nonsense back then. And they were dead wrong, of course.
At Zeal we are hardcore contrarians, brave when others are afraid and afraid when others are brave. This approach isnít easy, as we are always fighting popular consensus to buy when everyone else is selling (bottoms) and sell when everyone else is buying (tops). Interestingly, that angers people. But it is necessary in order to buy low and sell high and grow fortunes in the stock markets. So ever since I founded this company in 2000, Iíve ensured weíve gone above and beyond in transparency.
Each week we write a web essay like this one, discussing some of our current research. All 598 are freely available on our website. Want to see what we thought in March 2009 when everyone was scared and feared a new Great Depression? I called the exact bottom and said to look for a new cyclical-bull market. How about August 2010 when those silly Hindenburg Omen fears reigned? I said the markets were very bullish, with no panic or crash coming. And I was very bullish in early October 2011 too!
In addition, the complete archive of every monthly newsletter weíve ever published is available online for our subscribers. And we also maintain a public record of every newsletter stock trade weíve ever made on our website, for anyone to examine and cross reference back to the underlying newsletters. Anyoneís credibility in the stock markets is completely dependent on their past success or lack thereof. No one who is really competent will object to anyone digging into their track record.
By checking what some analyst was expecting at previous known major bottoms, you can immediately know whether he is a contrarian (fighting the crowd) or a weathervane (reflecting the crowd). If some fearmonger was also fearmongering at past major bottoms when he should have been very bullish, why on earth would you even think about trusting him today? Analysts who are bullish at major highs and bearish at major lows are going to cost you dearly, wrongly convincing you to buy high and sell low.
And many fearmongers are actually perma-bears, perpetually bearish. This stance is absolutely useless for speculators and investors! Even in secular bear markets like todayís, the stock markets flow and ebb. Despite the stock markets grinding sideways on balance since 2000 as I predicted they would way back in 2001, weíve seen two mighty cyclical bulls powering 101.5% and 101.6% higher. The commodities stocks we were trading nicely amplified these underlying SPX gains.
Since 2001, all 591 stock trades recommended in our newsletters have averaged stellar annualized realized gains of +51%! Our contrarian approach of ignoring fearmongers has been wildly successful. If you want to thrive in the stock markets, we publish acclaimed weekly and monthly subscription newsletters that can teach you how. In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what the markets are doing, why, and how to trade them with specific stock trades as opportunities arise. Subscribe today and start thriving!
The bottom line is succumbing to fearmongering is a huge risk faced by speculators and investors alike. Fearmongers lead traders astray, convincing them to be bearish and sell (or not buy) at exactly the wrong time. If you listen to them near major market lows, your capital invested in stocks will quickly erode away. You will get discouraged and miss out on multiplying your savings into a fortune in the stock markets.
Thankfully, fearmongering and fearmongers are pretty easy to identify. When fear as measured by the implied volatility indexes is very high, you can immediately discount near-term bearish theories as fearmongering and ignore them. And if some analystís ideas are making you bearish after a selloff, simply check out what he was saying near past major bottoms. If he was bearish then too, he is a fearmonger.
Adam Hamilton, CPA November 4, 2011 Subscribe at www.zealllc.com/subscribe.htm