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Making Sense of the Senseless

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Hello, Reader. 

Dave Gilbert here, Editor of Smart Money. 

Newsflash: Investors don’t like the market right now.  

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

That’s not really a groundbreaking statement, yet we keep seeing headlines and articles harping on about how poor “investor sentiment” is right now.  

In fact, recent readings show that sentiment is at its crummiest in decades… possibly ever.  

But for being such a heavily relied-upon indicator, does it really tell us anything more than what we already know?  

Let’s see… 

Investors Are Extremely Grumpy  

It’s been quite a week. The Fed hiked interest rates three-quarters of a percent yesterday, the biggest increase since 1994.  

And… it’s the first time ever that the Fed raised rates 0.75% while a big, bad bear has taken up residence on Wall Street.  

The S&P 500 is down more than 22% as we approach the midpoint of the year… so yeah, there’s no wonder why sentiment is lousy.  

It’s so lousy that it’s become rather interesting.  

Sentiment is often a contrarian indicator. When it’s really bad, it often means the market is closer to the inevitable shift back toward historical norms.  

But how bad is it? The most recent Bank of America survey of global fund managers showed optimism regarding global growth is at an all-time low… 

Lower than when the pandemic hit two years ago. Lower than the devastating 2008-2009 financial crisis. Lower than the bursting of the dot-com bubble in 2000.  

Then, there is the so-called “fear index” – the CBOE Volatility Index (VIX) – which is based on options activity on the S&P 500.  

Below is a chart of the VIX going all the way back to 1990. Notice first that it has only exceeded 40 four times, and it got as high as 35 on Monday and is back up near that level today.  

The big spike in the middle is the fall of 2008 in the throes of the financial crisis, and the second-biggest spike to the right is March of 2020 as the pandemic hit. The VIX is nowhere near those historic highs, but you can see that it is currently in pretty rare territory, nonetheless.  

Then, there are individuals. On a consumer level, sentiment is in the tank. The recent University of Michigan survey just hit its lowest level. That’s serious, as consumer spending makes up roughly two-thirds of the economy.  

In terms of investing, the American Association of Individual Investors (AAII) conducts a weekly sentiment survey, and nearly 60% of investors (58.3% to be exact) are bearish. That’s the 15th-highest bearish reading in the last 35 years and almost double the historical average of 30.5%. In fact, it has been above the average for 29 of the past 30 weeks.  

And that brings us to the point, which is plainly stated on the AAII website:  

The Sentiment Survey is a contrarian indicator…

Unusually high bearish sentiment readings historically have also been followed by above-average and above-median six-month returns in the S&P 500.

It’s like the market’s version of the old proverb, “It’s always darkest before the dawn.”  

Extremes are, by definition, rare. After all, if something were always extreme, it would be normal.  

And because extremes are the exception rather than the norm, they simply cannot last. 

What Can Investors Do? 

Eric Fry told me this week that extreme negative sentiment almost everywhere you look could indicate that we are closer to some kind of reversal. But the truth is, nobody knows exactly when that will happen or, as Eric also said, how much further stocks might fall before they revert to a normal upward trend.  

Trying to pick a bottom is like a game of Whack-A-Mole. Right after you’ve smacked the critter down… another pops right up.  

It’s frustrating, complicated, and even painful to invest at times like this. That said, the worst things an investor can do are panic, try to time and predict the market, and/or give up.  

The market is a proven wealth generator over the long term, thanks to the inherent growth bias of capitalism. Eric and our other InvestorPlace analysts think sentiment could improve in the coming months – if and when inflation starts to come down and the Fed can become less aggressive with its monetary policy.  

What to do in the meantime? Here’s Eric’s advice… 

We should take a few minutes to reexamine each of our investments to be sure that we are still enthusiastic about each of their prospects going forward. At the same time, we should make sure that our total allocation to stocks aligns with our actual risk tolerance and investment objectives.

Run a simple test that goes like this: If a market selloff caused my stock holdings to fall 20%, would I be okay with it? What if my stocks fell 40%, would I be okay with that?

Another way to ask that same question would be: What would bother me more; missing out on a 30% gain… or suffering a 30% drawdown. Only you know the answers to these questions. 

No matter what cautious steps you might take, some level of regret is almost inevitable.

If you trim positions and the market soars over the next 12 months, you might regret that you sold anything. On the other hand, even if you sold half of your holdings before a major selloff, you would probably regret not selling even more.

There is no perfect, all-weather approach to managing risk. Long-term investing is both a science and an art. So that’s why I recommend taking profits along the way, while still continuing to invest in the most promising investments you can find… no matter what the market environment might be.

Many of the technologies in focus today are arguably more potent and transformational than those of two decades ago. But human psychology never changes – especially not the psychology that causes the stock market to cycle through periods of low valuation to high valuation and back again.

We should not take that risk lightly, but neither should we let it chase us out of the market completely. Instead, I recommend pursuing a disciplined, long-term strategy that is panic-resistant.

Bear markets are horrible, but we must remember that the market recovers 100% of the time. It’s ironic that perhaps the greatest certainty we find in investing is that the miserable money-losing times don’t last.  

The moves you make – or don’t make – during those times can significantly impact your own recovery. The decisions are not easy and emotions get involved, which is where an experienced and proven pro like Eric can help. I know how important risk management is to Eric, along with his focus on sweeping trends that look unstoppable even in the face of a tough market and economy.  

I encourage you to read our InvestorPlace special report called “What to Do When the Stock Market Drops.” CEO Brian Hunt offers important research and a valuable perspective on financial disasters through the years and how we should think about them.  

“History provides a crucial insight regarding market crisis,” said former fund Shelby M.C. Davis. “They are inevitable, painful and ultimately surmountable.”  

Regards, 

Dave Gilbert
Editor, Smart Money 

P.S. Managing your portfolio is all well and good, but I wouldn’t be surprised if you’re champing at the bit to add some more potentially profitable trades to your portfolio. All told, there is one sector that Eric says has consistently given its investors profits from the tumultuous start of the year until now – and before the market makes its reversal (or sentiment changes), it’d behoove you to act now and scoop up shares of this trade, before it’s too late. Details here. 

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