With every talking head, piece of breaking news, and with every point higher for on S&P 500 or the Dow, more and more reluctant investors are starting to "give up" and buy into the rally. This is the paradox that is investor behavior. For those who have been long-nervous, this last quarter has been gut-wrenching. We in the portfolio management world call this "The Pain Trade" because it's so painful to watch the market go up when you're sitting on the sidelines.
If you look back at history through all the market ups and downs, Dalbar studies have shown that these shy investors manage to wait until the market is near exhaustion before they "can't take it anymore" and they put their money to work. As the market rises at overbought levels, more of these shy-buyers that get in, the more exhausted the market becomes, and eventually - inevitably, the market corrects. When do those same investors who "got in late," get back in? You guessed it… after (or at least close to) the bottom of the correction. This is why Dalbar's study each year shows that investor behavior causes severe underperformance over bull and bear markets.
Study after study has been performed, proving time and time again, that the pain of loss is much more painful than the pain of missing out on gains. As I've often said in the past, "I'd rather be out of the market wishing I was in, than in the market, wishing I was out." With that said, it's important not to treat your portfolio like an On/Off switch. Rather, your portfolio should be treated like a "dimmer switch," dimming the lights on when risk levels are low - and turning the dimmer down, taking profits off the table as risk levels become elevated.
There is a huge difference between uncertainty and risk. With risk, we know the outcomes. When it comes to uncertainty, the outcomes are unknown, but we must prepare for them. We know what happens in high risk environments with in the markets because we've seen them in the past - and we've seen the fallout that ensues thereafter. The uncertainty is, when (not if) the market starts to aim downward, how far will it go?
Ignoring the present high-risk conditions, considering how many times it's happened before, is a lot like driving your car towards a railroad crossing with the rails down and lights blinking. This market won't necessarily crash, but sometimes it makes a lot of sense to slow down, wait for the train to pass and the rails to rise before proceeding on your journey.
In the near term, the market is only as stable as its most unstable investors. Enjoy the party while it lasts, but don't allow a month or two of new highs trick you into thinking the market will only go straight up from here without a stop for gas.
In my view, the SPX is starting to top out. Monday's drop (fueled by China GDP, the gold sell-off, margin calls, more gold selling, and the iced with the Boston Marathon tragedy) was partially recaptured yesterday... partially. Today, we're seeing another drop, which will likely result in a lower high on the S&P500.
Another rally to new highs isn't out of the question, but in my belief, we're dangerously close to a nice, healthy pullback. Starting to scale back offensive positions will lock in any YTD profits so you can step up into the expensive, covered seats with your blanket, soda, & popcorn. Now you can enjoy the show and wait for a good opportunity to buy back in at lower prices.
With that said, hopefully you didn't buy into the hype and give in to the pain trade this past week or two. If you did, it's not to late to scale back and stop out of your positions now. The black jack player who won't leave till he gets his money back is usually the player who keeps his mouth shut on the return flight home.
What's the worst that could happen? The market could continue going up for the rest of the year without a correction. The odds of this happening? Slim to none.