With the plunging stock markets terrifying traders,
many are running for the hills. Steep selloffs always generate intense fear,
a scary emotion from which we humans are naturally hardwired to flee. But in
the stock markets, major fear spikes should be embraced. They mark the best opportunities ever seen to buy low, the necessary prerequisite
to selling high and multiplying your wealth.
The ideal time to buy low is when everyone else is selling, and we have
seen that in spades over the past couple weeks. The flagship S&P 500
stock index (SPX) plunged a brutal 16.8% in only 11 trading days. Well over a
third of this selloff was condensed into a couple seriously-nasty ones. On
Monday alone, the biggest and best American companies represented by the SPX
collectively plummeted 6.7%!
This bloodbath ignited a massive fear spike, with frightened traders predicting a new
recession and panic-like cascading selling. While the plunging markets made
all these scary prognostications seem rational, they were anything but.
Traders and the financial media always shape and spin newsflow
to rationalize whatever emotions
they happen to be feeling. Scary price action drives scary newsflow.
Short-term stock-market action is not driven by
fundamentals like corporate earnings and economic data, but by greed and fear. After a long rally,
greed waxes too extreme leading to stock prices getting too high and
overbought. From such conditions corrections are born, as I warned back in mid-April as
the SPX approached its post-panic highs. Unfortunately these dangerous times
are when most traders want to buy.
Then after corrections, fear mushrooms to blinding
intensity which drives stock prices to irrationally-low and oversold levels.
This is exactly what we saw this week. Out of these bleak episodes, huge
rallies are spawned. The best time to buy low is when the thundering herd is
convinced the stock markets are ready to plunge off a cliff. The resulting
bargains are incredible, the lowest prices seen in any ongoing bull.
Trading fear is the easiest and surest way to earn a
fortune trading stocks. But first this ethereal emotion must somehow be
quantified. While fear can’t be measured directly, it can be inferred
through sentiment indicators. My favorite is the venerable old-school VIX,
the S&P 100 implied-volatility index now known as the VXO. It measures
the implied volatility of at-the-money options expiring one month out in the
biggest, most-liquid, and most-responsive stocks of the S&P 500 (its top
20%).
This proxy for fear is far superior to today’s
VIX, a bastardized version hatched back in September 2003. Even though it is
the biggest and most-liquid stocks that are sold fastest in a selloff,
today’s VIX includes the entire S&P 500 which is much less
responsive than its leading S&P 100 companies. Even though at-the-money
options prices move fastest in any selloff, today’s VIX is diluted with
out-of-the-money options. What passes for the VIX now is inferior and
sluggish compared to its original namesake, today’s VXO.
Whenever this decades-old VXO surges rapidly to high
levels, it signals excessive and
unsustainable fear. While powerful, this emotion is finite. Eventually
everyone who is going to be scared into selling by falling prices will have
already sold, leaving only buyers. And at that exact fear climax is right
when the biggest rallies ever seen in the stock markets suddenly ignite.
Riding them yields enormous profits.
While this buy-fear-sell-greed truth extends back
through all of financial-market history, I’m going to focus on just our
current cyclical bull today. It was born out of extreme fear back in March 2009, a
time when everyone was convinced we were on the verge of a new depression after 2008’s epic
stock panic. But between that very despair and late April 2011, instead the
flagship S&P 500 soared 101.6% higher in a mighty cyclical bull. Like all
bull markets, this one experienced periodic selloffs to rebalance sentiment.
All of these major periodic selloffs are labeled in
this chart, divided between pullbacks and corrections. Pullbacks are smaller
stock-market selloffs of less than 10%, while corrections exceed this
threshold. Far from being the threat they’re always perceived to be at
the time these selloffs occur, they’re essential for a bull’s
health. They prolong bull markets by bleeding off excessive greed and
rebalancing sentiment.
Note that every single pullback and correction of
this entire cyclical bull
witnessed a parallel fear spike as evidenced by the surging VXO. Naturally
the degree of fear varies proportionally to the magnitude and sharpness of
the SPX selloff. Bigger and faster selloffs ignite more-intense fear than
smaller and milder ones. Nevertheless, all saw significant fear spikes as
measured by the definitive VXO fear gauge.
The biggest fear spike of this entire bull, before
this past week’s brutal selloff, erupted in the summer of 2010. It
started in May 2010 with the infamous Flash Crash, a crazy 4.5% SPX plunge in 5 minutes. This selloff grew into a
full-blown correction in which this flagship stock index surrendered 16.0% in
about 10 weeks. This drove the VXO as high as 43.6 mid-correction, and 33.8
by the time it had run its course.
Now you may not remember just how bleak things
looked last summer after this major stock-market correction. Big mainstream
financial news was an obscure but notoriously-unreliable indicator ominously
named “the Hindenburg Omen”. Traders universally feared another
panic, an irrational belief I
attacked right at those depths of despair. And what happened after those
scary lows of last August? The SPX soared 30.2% higher by late April 2011!
Fear should be aggressively bought,
never sold.
Go back and read financial news and commentary from
July and August 2010 after this cyclical stock bull’s first correction.
What the heck were traders so worried about then? The same things we heard
this week! A slowing US economy as well as the endless European sovereign-debt
woes and default threats dominated psychology at one of the best buying opportunities of this
entire bull market. Traders caught up in this irrationally-pessimistic newsflow, cowering in cash,
missed a wildly-profitable upleg.
Now today we find ourselves in the second correction
of this bull, a 17.9% SPX decline over 14 weeks that is roughly the same
magnitude as summer 2010’s 16.0% over 10 weeks. This steep selloff has
dredged up the same old slowing-US-economy and European-sovereign-debt fears.
Traders are scared, with the perma-bears, pessimists, and chicken littles
doing their best to convince everyone a new stock panic draws nigh. And look
at the resulting fear spike, it is utterly massive!
Prior to today’s ninth major selloff of this
cyclical stock bull, the average VXO peak within a couple trading days of the
SPX’s bottoms was 28.3. With the exception of the only other full-blown
correction last summer, this level of fear was sufficient to temporarily
bleed off greed and rebalance sentiment. But this week on Monday’s
brutal 6.7% SPX plunge, its biggest down day since December 2008 in the heart
of the stock panic, the definitive VXO fear gauge skyrocketed 50% higher to
close at 49.4!
The more extreme fear gets, the more compelling the
buy signal. After every other pullback and correction of this entire bull,
the SPX rallied sharply as you can
see in this chart. And all of these other fear spikes except the other correction’s were
relatively minor. A 28ish VXO is nothing compared to a 50ish one, the fear
isn’t even in the same league. A 50ish VXO is inarguably, absolutely extreme fear!
It brought back some fond memories for me. Nine
years ago this very week, I wrote
my first essay on the VIX (today’s VXO). Called VIX Bounces S&P 500, it chronicled
how 50ish VIX reads absolutely marked major bottoms and the
highest-probability-for-success buying opportunities ever seen in bull markets and bear markets alike. You will never
get a better, surer buy signal than a 50ish VXO, it is the pinnacle! So
naturally we aggressively plowed capital into radically-oversold commodities
stocks this week.
Now there is one exception to this 50ish VXO
ceiling, and that is panics and crashes. If we are heading into a panic or
crash as popular sentiment suggests, the VXO can temporarily surge a heck of
a lot higher than 50. Back in October and November 2008 during that epic
stock panic, the VXO skyrocketed up into the high 80s! So should contrarian
investors and speculators prudently buying extreme fear worry about a new
stock panic or crash anytime soon? Definitely not.
Panics and crashes are very specific and
exceedingly-rare events. A panic is a 20%+ plunge in the stock markets in a
matter of weeks that only occurs
out of lows late in cyclical bear
markets. But we are not late in a cyclical bear today,
we’ve been in a cyclical bull since March 2009. Panics cascade out of
bear-market lows, but we weren’t far from bull-market highs when this
latest selloff started. These events are never seen close together either,
2008’s was the first true panic since a century earlier in 1907!
Just as panics only occur at one specific point in
bull-bear cycles, so do crashes. They are 20%+ plunges
in the stock markets in a matter of
days, and only erupt out of multi-year highs deep in secular bulls. We are not only in a secular bear today,
but this latest selloff started accelerating from well under late
April’s SPX highs. The cycles are all wrong for another crash today
too, it isn’t going to happen.
These bull-bear cycles are incredibly important to study, as knowledge of them and the Long Valuation Waves
that frame them is absolutely critical to long-term investing success.
Expecting a panic or crash at the wrong place in these cycles is like
predicting an epic blizzard in July. No matter how much people fear snow, a
wicked snow storm simply can’t exist outside the bounds of the seasonal
cycles.
And panics and crashes create such immense fear that
they are effectively once-in-a-generation
events. It takes decades to
build enough complacency and greed to fuel such epic selling events. They are
like massive wildfires. You can’t have a huge once-in-several-decades
wildfire just several years after the last one. There simply isn’t time
for enough new fuel to grow back in. Expecting another panic so soon after
2008’s is like expecting an epic wildfire in an area thoroughly burned
out just a few years earlier!
Despite this, after every major correction people
irrationally expect a panic or crash. These big selloffs frighten them so
much that they sell near lows, so
they need to cling to some theory to rationalize their poor decisions. Thus
fears of a panic or crash are simply another bottoming indicator, an aspect
of any large fear spike that helps define incredible buy signals. I’d
be concerned if panic, crash, recession, depression, new-bear, and
sovereign-default talk didn’t
exist today!
That new-bear thread is worth pondering. Every
correction sees intense fear that a new cyclical bear market is being born.
This is certainly possible today, but not probable. Back in late June I wrote
an entire essay showing in bull-bear-cycle terms why a new cyclical bear
isn’t likely today. While a new bear is a vastly-higher probability
than a panic or crash, it is still too low to worry about right now. During
summer 2010’s correction new-bear fears flourished too, yet look at the
mighty SPX upleg since.
Buying fear, being “brave when others are
afraid” as Warren Buffett sagely articulated, is the surest way to buy
low in the stock markets. Fear leads others to sell, which drives stock
prices down to irrationally-oversold levels totally disconnected from their
core earnings fundamentals. If you can steel and harden yourself to fight
your own fear, to buy when you least
want to, you can capitalize on these awesome bargains.
While a 50ish VXO is effectively an absolute ceiling
on stock-market fear except in once-in-a-generation panics and crashes, I
also like to look at fear in relative
terms. VXO 50 approaches are so darned rare that many years ago I had to
figure out a way to grade lesser fear spikes. I needed a shorter-term
baseline for fear, and settled on the VXO’s 200-day moving average. I
used my highly-profitable Relativity Trading
system to quantify the VXO as a multiple of its 200dma. Over time this
forms a horizontal trading
range.
The raw VXO is rendered in blue here, slaved to the
right axis. The Relative VXO, or rVXO, is shown in
light red on the left. Over the past 5 years or so, this
VXO-divided-by-its-200dma multiple has tended to oscillate in a range between
0.75x on the low side to 1.75x on the high side. When the VXO slumps to 75%
or less of its 200dma, odds are fear is too low (therefore greed is too high)
so an imminent pullback or correction is likely.
Conversely when the VXO soars to 175%+ of its 200dma
during a stock-market pullback or correction, the odds grow overwhelming that
fear is too extreme to be sustainable. Every SPX pullback and correction from
the first chart is also numbered on this VXO chart, along with the rVXO reads near their bottoms. Note that at an insane
2.75x its 200dma this past Monday, we’ve just seen the highest relative
fear reading of this entire cyclical bull!
The more extreme any fear spike, the greater the
odds it is unsustainable. And the selloff that drove it is effectively over
since everyone susceptible to getting scared into selling anytime soon has already sold. The last time we saw
such wild 2.75x rVXO readings was back in October
2008 in the heart of the stock panic, right before the SPX soared 18.5% in
just over a week in a monster bounce rally!
Whether you want to measure it absolutely with the
50ish VXO ceiling or relatively compared to its 200dma, fear as measured by
the VXO was off-the-charts high this week. Such extreme fear is never sustainable, it almost instantly burns
itself out like a flaring match head. Super-high absolute or relative VXO
reads simply have to be bought aggressively. Extreme fear drives
irrationally-low stock prices, but these incredible bargains are very fleeting.
While I certainly didn’t expect a massive
50ish VXO spike or the brutally-fast SPX plunge necessary to spark it, I was
warning in mid-June in my original Trading Stock Fear
essay that a big fear spike was overdue. And only a full-blown stock-market
correction could spawn it. So while the exact magnitude of any fear spike is
unpredictable, they do occur with some regularity as healthy pullbacks and
corrections periodically rebalance sentiment. Coming out of a low-fear
environment, a fear spike should surprise no one.
After a quarter century of trading stocks, I know
exactly how hard it is to battle the greed and fear in my own heart. Being a
contrarian, being brave when others are afraid and afraid when others are
brave, is very challenging. It is stressful and wearying to fight the herd,
to do the opposite of what everyone else thinks is prudent at the time. Yet
it is worth every ounce of angst because the rewards are so high.
At Zeal, we’ve been buying fear and selling
greed publicly for over a decade now. Since 2001, during a sideways-grinding secular stock bear no less, all 591 stock trades
recommended in our newsletters have averaged annualized realized gains of
+51%! We didn’t achieve this by buying high when it felt good and
selling low when everyone was scared, but by doing the exact opposite. Contrarian trading is the only way you can
grow your capital at 50%+ per year, which multiplies your wealth at a
dazzling rate.
And after realizing huge profits earlier this year
as the SPX hit new highs, we have again started buying aggressively. In the
past couple weeks alone, we’ve added 14 new stock trades and 4 new
options trades in our newsletters! If you can muster the courage to buy fear,
if you want to thrive in these stock markets, subscribe today to
our acclaimed weekly or monthly newsletters!
In them I explain what the markets are doing, why, and where they are likely
heading next. You can mirror the actual trades we are making.
The bottom line is this past week’s
stock-market plunge ignited incredibly-intense fear. The definitive fear
gauge skyrocketed so high that it slammed into its effective ceiling in
normal market conditions. Such extreme fear is absolutely unsustainable, as
it scares all the weak hands out of the markets and burns itself out. But it
drives stock prices to absurd hyper-oversold levels, creating incredible
buy-low bargains.
Sadly, the great majority of investors and
speculators haven’t trained themselves to fight the crowd. Instead of
buying low in extreme fear, they sell low. Then they stay out until long
after the markets have rallied dramatically, only belatedly returning to buy
high. It is only the contrarians, the wise minority that have hardened and
steeled themselves to trade fear rationally,
that buy low, sell high, and earn fortunes.
Adam Hamilton,
CPA
Zealllc.com
So how can you
profit from this information? We publish an acclaimed monthly
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that details exactly what we are doing in terms of actual stock and options
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Questions for
Adam? I would be more than happy to address them through my private
consulting business. Please visit www.zealllc.com/adam.htm for
more information.
Thoughts,
comments, or flames? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that I
am not able to respond to comments personally. I will read all messages
though and really appreciate your feedback!
Copyright 2000
- 2006 Zeal Research (www.ZealLLC.com)
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