Timing stock market complacency

‘What? Me worry?’ would be MAD magazine cover boy Alfred E. Neuman’s attitude about the stock market. But The MoneyLetter’s behavioural finance analyst, Ken Norquay, has his own take on investor complacency.  Mr. Norquay’s mantra is ‘Complacency? Not me!’ He explains his approach to determine when to exit and re-enter the market.

Happy First Birthday! One year ago the U.S. stock market trend reversed itself and dropped down. The high was reached on May 20/21, 2015. This commentator recognized it three months later. Looking back over the past year, the downtrend is barely noticeable!

As of May 1, 2016, the S&P 500 Index was down only three per cent. Were it not for the dramatic drops in the U.S. stock market in August and January, the past year’s action would scarcely be a downtrend. And the recoveries following those two declines made back most of the losses. Our baby bear market has hardly grown at all in its first year.

The Canadian stock market’s downtrend is easier to recognize: it began in September 2014, a full 20 months ago. The TSX Composite Index is down seven per cent per year since its high.

Recognizing these downtrends, our emphasis as investors should be on reducing our exposure to the stock market and building up cash reserves, patiently waiting for the inevitable future stock market bottom. How will we be able to judge when to re-enter the market? What should we look for at the bottom of the cycle?

The three Cs of a bear market

In my stock market book Beyond the Bull, I explain Bob Farrell’s famous “Three Cs of a Bear Market”. In the early stages of the downtrend, investor complacency is most prevalent: they see prices going lower, but they aren’t really worried about it.

The second C is concern: investors see the downtrend and become concerned about it. (There were flashes of concern in institutional circles when those two sharp, short-term declines occurred last August and January.) As concern grows, selling increases and the downtrend starts to gain traction.

The last of Farrell’s Three Cs is capitulation. Institutional investors realize they have to seriously reduce their exposure to the stock market – their mass selling creates a selling climax and the downtrend ends.

Knowing this sequence, we can easily see that as private investors, our best course of action is to sell sooner rather than later. This puts us in a position to buy back into the stock market when the institutional fund managers’ capitulation finally ends the downtrend. Easy in theory: not so easy in the greed/fear world of economic reality.

Bob Farrell was the chief market strategist for the U.S. investment firm Merrill Lynch. When I worked for Merrill Lynch all those years ago, I read his work diligently. I considered him to be my mentor.

But as I gained experience, I realized how tricky the economic cycles really are. Economics unfolds in seasons, just like nature. There is a planting season, a growing season, and a harvesting season. Then follows the season of destruction: economic winter.

Cycles and emotions

But economic cycles do not follow nature’s calendar. They follow the cause-effect cycles of human emotions. That’s what Farrell’s Three Cs reveal. A stock market downtrend begins with greed and ends in fear. Greed seems like a cruel word. After all, what’s wrong with wanting to get a reasonable return on one’s money? And, when we say that a bear market ends in fear, what’s wrong with wanting to preserve what one has?

Investors’ problems come from two sources:

1. Failure to recognize a change in a trend, and

2. Failure to act.

Farrell’s Three Cs were concocted to help us line up our expectations with reality. For example, the U.S. market declined three per cent over the past year, and the Canadian declined at an annual rate of seven per cent for the past 20 months.  Does anyone care? That’s what stock market complacency is: we see what’s happening, but don’t care. What is motivating this lack of concern? Is it an unreasonable desire to make even more money from the uptrend that began in 2009? Is it greed?

When I was a stockbroker with Merrill Lynch and I tried to encourage people to sell, they would often say: “But what will I do with the money? T-bills only pay X per cent!”

It was difficult for those investors to grasp the idea that having a reserve of cash earmarked for buying into the stock market near the bottom is a valid strategy. It was as if they only recognized uptrends: for them, downtrends are merely “corrections” in uptrends. Greed makes us think incorrectly. Greed makes us assess risk incorrectly. Greed causes losses.

Complacent investor? Who me?

The formula for using Farrell’s Three Cs correctly is to feel those feelings in reverse order. When the crowd is feeling complacent, we should feel fear. (For example, RIGHT NOW!) When the majority is becoming more concerned, we should try to judge how concerned they are. As their concern, worry and anxiety increase, we should feel more and more confident, relaxed and patient. And when institutional capitulation ends, we will, in a most careful and concerned way, buy back into the stock market.

Why is the U.S. bear market so weak so far? The 2008-9 drop/crash was followed by a recession, the bankruptcy of General Motors and an international banking crisis. The solution to these economic problems was the creation of mass liquidity in the banking system. And it worked! Economies and markets responded by stabilizing. This liquidity-induced stability is still operating. That’s why this bear market is so weak after one year.

Let’s examine other financial trends to see if it helps us develop more concern now, when others are complacent.

The trends for oil, oil stocks and the Canadian dollar are strongly correlated. Oil stocks and the Loonie had short-term bottoms in January, and the price of oil itself bottomed in February. All three have enjoyed strong rallies since then. It is too soon to determine that their long term downtrends have ended. Once the current rally peters out, and their short-term trends turn down again, we will better able to judge the longer-term trend. These three financial indicators can reverse their long-term downtrend in two ways:

1. The first would be for their prices to drop back to the vicinity of the January or February lows – and to not drop further, even though most analysts forecast lower prices. If their prices then start to rise, we would have confidence that these three downtrends are over. This would be a divergence between what analysts and investors expect and what actually happens. That divergence signals the bottom.

2. The second way it could happen is less exciting: the prices drift sideways, not going up or down for a year or two. Chartists call this action ‘base building’. Then one day, prices will gently start to ease upward, almost unnoticed, and the new stock market uptrend will emerge.

For now, these short-term uptrends, these rallies of 2016, are mature. If you need to convert your Canadian dollars to U.S. for a vacation, this is probably a good time to do it. If you are a professional portfolio manager who is still over-weighted in energy stocks, this is probably a good time to ease out. If you are a major oil company wondering when to restock your fuel inventory, you would be better to wait a few months.

Investors who still love the Canadian bank stocks should note that all five are in weak downtrends that began in the third and fourth quarters of 2014. Most investors say they hold Canadian bank stocks because of their dividends: they don’t mind if share prices go down. Could this be an example of Farrell’s “Complacency?”


The MoneyLetter, MPL Communications Inc.
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