When A Chihuahua Draws Blood

| About: SPDR S&P (SPY)

Summary

Investors often overcompensate and overreact in the heat of the moment.

Assets were withdrawn from markets and various strategies right at the bottom of the drawdown, when instead buys should have been made.

The only very near-term fly in the ointment? Utilities and Treasuries should have weakened a lot more into the broad reflation rally.

"I believe a calm dog is a happy, obedient dog that won't get into trouble." - Cesar Millan

Co-Portfolio Manager Ed Dempsey needed to call a plumber this week for his place. When the plumber arrived, Ed inquired if he was afraid of dogs given the presence of his own (who happens to also be our Director of Security). The plumber said only small dogs frightened him, largely because a Chihuahua drew blood on him a few weeks ago. Well, that got me to thinking. While large dogs can appear scary, more often than not a few barks are all the big dog needs to do to establish dominance. Big dogs know they are formidable foes, and don't need to do much to make sure a stranger knows it. Chihuahuas though? When they see a stranger, they bark incessantly and can become quite violent, going so far as actually biting a leg and drawing blood.

Now I know what you're thinking: "where the hell is Michael going with this?" The overcompensation the Chihuahua expresses because of his small size ends up being effective in the moment. The dog made the plumber bleed by taking a bite out of his leg. But that overcompensation for the dog's miniature size by enacting violence is actually harmful long-term not to the plumber, but to the Chihuahua. Future visits by plumbers or repairmen might result in the dog being put in a cage or locked in a room. The owner would likely yell or punish the dog for his brazen and unprovoked attack that was driven by fear of the considerably larger plumber.

Investors often overcompensate and overreact in the heat of the moment. When volatility (the plumber) arrives, fight or flight becomes the mode investors (the Chihuahua) instantly turn on. Volatility comes and goes, but fear of the larger market by the smaller investor results in that investor overcompensating not by taking a bite out of the market, but by taking a bite out of a portfolio, often selling out of an entire position near that position's lows. Felt right at the time, seemed effective that day. Blood has been drawn, and the investor has won against the market. Unfortunately, by doing this, the investor panics out just as a powerful rebound is about to start, no different than just before the plumber's job is done and things return to normal.

I'm always amazed how consistent this overcompensation is by investors, who have a habit of buying a position slowly in pieces, but then selling out of everything long after volatility has already arrived. Stocks (NYSEARCA:SPY) are now broadly positive for 2016, despite the hysteria that began at the start of the year. If stocks hold onto their gains, this would be the largest quarterly comeback for the Dow (NYSEARCA:DIA) since 1933. Yet, so few actually held on following the first two weeks of the year that only those who didn't draw blood in their portfolios benefited. Assets were withdrawn from markets and various strategies right at the bottom of the drawdown, when instead buys should have been made.

Now, everyone suddenly feels good about the stock market again. They love stock prices and buy into them at higher prices, but don't actually follow through on true investing which is buying low. Of course, the question is what happens next. Indeed, inflation expectations have had a significant comeback, primarily due to the massive rip higher in Oil (NYSEARCA:USO) (which of course everyone is now bullish on at $40 as opposed to $30).

The only very near-term fly in the ointment? Utilities (NYSEARCA:XLU) and Treasuries (NYSEARCA:IEI) should have weakened a lot more into the broad reflation rally (important as shown in our award winning papers which can be downloaded here). This may be a false positive, or it may be warning that odds favor another dip lower in the very near-term. Should that happen, the reaction by investors who don't stick to a strategy which attempts to get ahead of the drop will likely be the same: overcompensate and sell towards the lows again. Either way, blood will be drawn in the short-term, and result in longer-term wealth repercussions. An overreaction built not on leading indicators, but on threat overcompensation.

Bad dog!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.