Call me a Pessimist

| | Economy

All investors know the adage to “buy high and sell low” but few adhere to it.  We can see this with record volume to start July trading coming mostly from retail investors as the S&P reaches another all time high.  Perhaps I have been in the futures industry too long because when things are “too good” I get concerned.  Oftentimes I am right though, even for accidental reasons.  

Oddly, the current period looks pretty similar to a time of recent memory.  Coming into February of 2020 the economy was on fire with record low unemployment, a rising stock market, and no immediate threats on the horizon.  A pandemic and a 30% loss in just over a month changed everything. While we hope this is a once in a lifetime event, a similar scenario has played out before as well. On January 26, 2018 the stock market hit an all time high and by February 8th (9 trading days later) entered market correction territory (10% below high). This was the result of investors piling into short VIX funds that reversed quickly causing a rush for the exits and the implosion of those strategies. It may seem odd conceptually to go from peaks to drops so quickly but there are reasons for it beyond what we would normally consider.  

Traditionally, one explanation is that weak hands enter the market late and get shaken out early. I view this a bit differently. When we look at overbought or oversold conditions, we see a market imbalance where we have more buyers than sellers or vice versa.  Perhaps now is a current example.  As we see the economy open up, many people finally feel comfortable putting their money to work especially as they see everyone else making money.  The downside to this is that we are left with few on the sidelines so when there is a correction, we need to drop a long way to get few remaining buyers off the sidelines.  Additionally, institutional traders often set trailing stop losses, so as stocks fall these stops are triggered increasing the rate of selling. Ultimately, this vacuum is filled seemingly at an increasing rate over time.    

Much like the casino when you are winning, it is hard to step away from the table and selling any asset that is doing well is neither easy nor wise in many cases.  So, what is an investor to do?  

In my opinion, adding strategies that benefit from volatility is step one.  While these may be frustrating to watch in “normal” times they often provide help when it is needed most.  Diversifying into asset classes that have different drivers than the bulk of your portfolio is step two. Traditionally, bonds accomplished this task but at current levels upside is limited and, in many cases, they are moving in concert with the market. Lastly, allow yourself to be a pessimist.  If everyone else thinks nothing can go wrong, remember the first quarter of 2020 and prepare accordingly.