It’s sure been an exceptionally-ugly week in the US stock markets! The threat of Washington defaulting on its debt, worse-than-expected economic data, and the waning of Q2 earnings season conspired to wallop equity prices. The resulting sharp selloff has led to soaring anxiety and fear, traders are rushing for the exits. But these scary conditions are a contrarian’s dream, an ideal time to snatch up bargains.
Legendary investor Warren Buffett is a bottomless font of fantastic investing wisdom. One of my favorite quotes from him is "Be brave when others are afraid, and afraid when others are brave." This simple concept is the core foundation of all contrarian speculation and investment. If you want to buy low and sell high, the best time to buy low is when everyone else is scared. It is their collective selling that drives stocks to deeply-oversold bargain prices.
And with the flagship S&P 500 stock index (SPX) plunging 6.8% in just 7 trading days by Tuesday, naturally the majority of traders are afraid now. They are selling with reckless abandon, fretting about Washington’s out-of-control spending, European sovereign debt, poor economic data, and all kinds of other things. Thus stock prices in popular sectors from technology to commodities have been crushed.
Our natural instinct during such carnage is to join the frightened herd in racing to dump stocks. The great majority of traders lapse into this groupthink behavior, being afraid when others are afraid. But for the contrarians who’ve trained and hardened themselves to fight the crowd, intense selloffs are harbingers of great opportunities. Aggressively buying stocks in their fear-filled hearts nearly always leads to huge profits within a matter of months.
I’ve been a contrarian speculator and investor for decades, so I’ve experienced countless times how challenging it is to be brave when others are afraid. Buying into a fear maelstrom is never easy, as there are always endless reasons advanced why stocks ought to imminently plunge much lower. But this strategy’s fruits are wildly profitable.
The key to fighting the fear in your own heart, to forcing yourself to buy when everyone else is selling, is perspective. The tyranny of the present hugely distorts our worldview, we all want to extrapolate current events (in the markets or life in general) as persisting out into infinity. But just when things seem least likely to change is right when a major change is probably coming. Charts really illustrate this in the markets.
Considered even in the brief context of 2011 alone, this past week’s SPX selloff is no big deal. The stock markets have been meandering in a broad trading range all year, surging up when traders feel optimistic and slumping down when they feel pessimistic. Understanding the SPX’s ongoing consolidation is crucial to recognizing the awesome buying opportunities these weak stock markets have created.
The flagship S&P 500 stock index is the best representation of the US stock markets as a whole, as well as the performance benchmark for all stock-market professionals. Despite some big swings, on balance all this SPX has done in 2011 is grind sideways in a high consolidation. This trading range’s overhead resistance has been around 1340 in SPX terms, while its foundational support has crystallized near 1270.
Consolidations exist because sentiment, how traders as a group feel about the markets, gets out of balance. After stocks rally far enough and long enough, traders forget the markets are risky and grow too greedy. This happened after the powerful 30.2% SPX upleg between late August 2010 and mid-February 2011. By the end of this awesome 6-month run, traders feared nothing and assumed stocks would keep rallying indefinitely.
But the SPX was very overbought, stocks had rallied too far too fast to be sustainable. By February this index was stretched 15.2% above its 200-day moving average! The SPX’s relationship to this critical technical line is rendered on this chart in the form of the Relative SPX in light red. It is simply the blue SPX line divided by its black 200dma line. The resulting multiple charted over time forms a horizontal trading range, as explained in depth in my essay on Relativity Trading.
Over the past 5 years, the SPX has generally topped when it stretched 10%+ beyond its 200dma. So 15% in mid-February was pretty extreme. I warned our newsletter subscribers about this at the time, and we realized big profits in our commodities-stock trades that had been added in the summer of 2010 the last time traders were afraid. And indeed, after hitting a new post-panic high of 1343 in mid-February, the SPX soon plunged in its first pullback of 2011.
Though it was the Libya revolt that acted as this selloff’s original spark, the particular catalyst that initially sends an overbought market lower is irrelevant. If catalyst A hadn’t driven the necessary selloff, then catalysts B or C soon would have. There is always plenty of good news and bad news out there for traders to digest, so they can easily spin prevailing newsflow to rationalize any buying or selling.
By several weeks later in mid-March, the SPX had fallen 6.4% in its first pullback. Despite this selling event straddling the terrible Japanese earthquake, tsunami, and Fukushima nuclear disaster, the SPX rapidly V-bounced out of the resulting oversold lows. It only spent a single trading day closing under 1270, the level that would later define its 2011 consolidation’s support.
Thinking back to market psychology near these mid-March lows is very useful for putting this week’s events in context. Back then, the country with the third-largest economy in the world was devastated. This had major bearish implications for global trade and economic growth. The first melting-down nuclear reactor in a quarter century threatened to spew radioactive debris into the atmosphere and ocean that could poison large swaths of our planet.
Traders were understandably very scared, as evidenced by the brutal 5% SPX plunge in a single trading week! Nevertheless, despite all these fears the SPX still V-bounced sharply as you can see in this chart. Now it’s certainly not that the Japan crisis improved in late March, actually the extent of the damage grew even worse as time allowed a deeper examination of the aftermath. US economic news wasn’t great either. But the stock markets still rallied sharply simply because they had been far too oversold.
The SPX’s big bounce stalled near its 1340 resistance in early April, but some high-profile Q1-earnings-season beats in late April temporarily drove this headline stock index above this line. But right after hitting a new post-panic high of 1364 in late April, the SPX started rolling over. This selling was moderate in May, but accelerated dramatically in early June. Again the SPX plunged 5% in about a week.
This early-June pullback’s boundaries were pretty interesting, as the meat of it started near 1340 resistance and it bounced right at 1270 support. While the SPX would spend a few trading days closing under 1270 before the stock markets rallied out of these lows again, this support essentially held as this chart shows. Together these two major bottoms defined this consolidation’s current trading-range support line.
Now as a contrarian speculator and investor, I was certainly disappointed with both of these pullbacks that bottomed in mid-March and mid-June. Given how overbought the stock markets had become in mid-February, I expected to see a full-blown correction. Corrections are bigger declines than pullbacks, with the line of demarcation separating them at 10%. Outright corrections are far preferable to pullbacks and consolidations for a variety of reasons.
Corrections, pullbacks, and consolidations all exist to rebalance away the excessive greed and complacency seen at major interim highs. The only thing that can combat these herd emotions is weak stock markets. Corrections are superior because they condense this painful process into the shortest-possible timespan, leading to oversold bargains and great buying ops much sooner. Pullbacks drag this rebalancing process out longer, while consolidations (sideways grinds) are much slower still.
If the SPX had actually fully corrected instead of just pulling back in March or June, we would have seen this week’s stock bargains way back then and been well into the stock markets’ next upleg by now. But a consolidation punctuated by smaller pullbacks takes a lot longer to rebalance away excessive greed and complacency. So when the SPX bounced in late June after two potential corrections failed to materialize, it became readily evident we were stuck in a grinding consolidation.
And indeed the SPX soon rocketed nearly 6% higher in only one week leading into July! This anomalous huge surge was not news-driven, there was little happening heading into the slow Independence Day holiday in the States. But low-volume buying pressure still materialized, driving the SPX to catapult rapidly from its 1270 consolidation support to its 1340 consolidation resistance. After briefly surging over 1340, the stock markets immediately rolled over and slumped until Q2 earnings season arrived.
Much like we had seen back in late April on the Q1 earnings, Q2’s in late July drove a minor SPX rally. But again the SPX couldn’t break decisively above its consolidation resistance no matter how amazing some of the high-profile earnings reports happened to be. And then again just like it had done heading into early June, the SPX plunged straight from resistance to support over this past week. Fast trading-range selloffs aren’t uncommon as major consolidations mature.
Last week I figured the SPX’s 1270 support line would hold in this selloff just as it largely did in mid-March and mid-June. But obviously the SPX kept right on plunging this week, knifing through 1270 on growing fears of an economic slowdown here and abroad. Is the failure of this consolidation’s 1270 support a big deal? I doubt it. So far this year the SPX has been able to occasionally trade over resistance and under support, yet these extra-trend price levels have never persisted for long.
By Thursday the SPX had spent three trading days under 1270 this week, compared to one in mid-March and three in June. Rather than being a threat, these sub-support days are a great opportunity. The lower the frightened herd irrationally drives stock prices, the better the entry prices for prudent contrarians who can buy into all this fear. This sub-support plunge also greatly increases the odds that this selloff is not only over or soon will be, but will lead to a new highly-profitable sustained cyclical-bull-market upleg.
Corrections are superior to consolidations for rebalancing sentiment because they drive stock prices deeper into oversold territory which ignites far more fear. At 0.975x its 200dma as of Wednesday’s close (the data cutoff for this essay), the SPX was as low relative to its 200dma as we’ve seen in this entire consolidation. Check out the light-red rSPX line above. It was also low in an absolute sense, nearing the 0.95x strong-buy signal in my Relativity trading system.
And this past week’s fast SPX plunge drove the first meaningful fear spike we’ve seen since mid-March. The best proxy for fear in the stock markets is the old-school VXO implied-volatility index. I recently wrote an essay on using it to trade stock fear, to buy stocks when the VXO surges in meaningful spikes and then sell stocks when the VXO drops too low again. These spikes mark major bottoming events, fantastic times to aggressively buy stocks.
After the VXO’s sharp spike in mid-March as this consolidation’s first pullback plunged under the SPX’s 1270 support, this headline stock index powered 8.5% higher over the subsequent 6 weeks. But during this consolidation’s second pullback bottoming in mid-June, there was curiously no meaningful fear spike. Without it, the SPX limped along near support for weeks before another rally could mount.
But during this past week, we have seen a new meaningful fear spike which is very bullish. The VXO had closed as high as 26.2 before the Wednesday data cutoff for this essay, and it traded much higher intraday on Thursday as this fear-laden selloff intensified. Since this SPX cyclical stock bull was born in March 2009, the average VXO close near the bottoms of every pullback and correction was 28.3. This week we were once again pushing this high-probability-for-success buying territory.
A steep selloff, surging fear, and traders exiting stocks in droves? It’s hard to imagine a better "be brave when others are afraid" scenario! The hardened contrarians who’ve painstakingly trained themselves to ignore their own innate greed and fear have a wonderful opportunity to buy low today. The great majority of traders are running scared with the herd, their selling driving stocks down to irrational, oversold, and unsustainably-low levels.
I’ve written many similar essays deep in major past selloffs, and the feedback is always similar. All of this contrarian stuff sounds logical, people reason, but how can we know when a selloff is over? How can we know where it’s going to stop, in pullback territory or stretching into correction magnitude? The truth is we can’t know, we mere mortals can never see the future. All we can do is game probabilities, nothing more. And the odds for a sharp rally immediately after a fast selloff and meaningful fear spike are very high.
Just like in March, the interim lows after fast selloffs like this week’s seldom persist for long. So buying a little early in one of these selling events is no big deal at all. Even if it isn’t over yet, and your stocks plunge lower with the markets, within weeks they will still have surged far above your entry prices. Personally since I can’t know the exact days of bottoms in real-time, I intentionally try to straddle my stock deployments across them to maximize my odds of getting the best entry prices. Some stocks are bought before the bottoming, some during, and some after. But all still surge dramatically as the SPX recovers.
The biggest threat in a major selloff like this is not gaming exactly when or where it will bounce, but whether it marks the transition between cyclical stock bull to cyclical stock bear. Buying stocks early in bear markets obviously leads to big losses. So if careful study and analysis (never merely selling-event emotions) lead you to believe we are entering a new cyclical stock bear within today’s secular stock bear, you definitely don’t want to buy stocks even given today’s oversoldness and meaningful fear spike.
But as I analyzed in depth in an essay in late June, the bull-bear cycles today argue that the past couple years’ cyclical stock bull likely remains alive and well. The probabilities of a new stock bear being born this summer remain fairly low. And there is definitely almost zero risk of another panic or crash so soon after 2008’s epic selling event, as I explained last August as traders also cowered in irrational fear. So with more cyclical-bull rallying likely, this buying opportunity ought to be seized.
The bottom line is the stock markets plunged to very oversold levels this week, resulting in fear surging. Whenever such intense selling events happen in the stock markets, they mark major interim bottoms. Oversoldness and excessive fear are never sustainable, regardless of current or near-future newsflow. And the subsequent rallies out of these oversold lows are big, fast, and highly-profitable.
It’s hard psychologically to fight the crowd and buy stocks when everyone fears the markets are ready to charge off a cliff. But it is exactly these fears that drive stock prices down to some of their best entry levels ever seen in an ongoing bull market. So if you can trade like a contrarian, be brave when others are afraid, the resulting realized gains are massive. Carpe diem, buy low now in this major stock buying opportunity!
Find out more information about Zeal's reports, and contact Adam Hamilton, CPA, at www.zealllc.com