Those of you who have seen the movie Animal House may remember the advice imparted by Brother Bluto. Flounder was lamenting the destruction of his brother's car. Bluto handed him a six-pack and uttered the sage words, "My advice to you is to start drinking heavily." By the end of the second week of 2016, the DJIA and S&P 500 were down 8% and the NASDAQ had dropped over 10%. During week three, conditions continued to deteriorate, making January 2016 the worst start to the year in history in the U.S. equity market. Those long stocks without protection have become intoxicated with losses.
Participation in the stock market in the U.S. is at a very high level given the amount of money tied up in IRA, SEP and other retirement and savings vehicles. Given that analyst projections for 2016 at the end of last year were for higher equity prices, many investors did not see the current sell-off coming. At the end of the first week of the year, little attention focused on stock market action. By the end of the second week, attention turned to falling stock prices. During week three, the reality set in with many asking the question, what do we do now? During week three, many analysts pointed to reasons like the Chinese economic slowdown, the Fed and rising interest rates, the high yield markets and the rise of the potential of emerging market debt defaults and falling commodity prices. It now appears that selling, which is has been almost a daily occurrence in equity markets, has created a risk-off environment.
The stock market has now fallen so far in such a short period that some investors have or will be clearing the decks or selling stocks and going to cash. When markets fall like knives, the natural reaction of human emotion is to step out of the way of those knives and to take all risk off the table. Many financial advisors are reminding their clients that those who sold during the depths of despair in 2008 should have remained with their investments, which recovered in the years that followed. However, when a macro sell-off event occurs, fear becomes the driving emotion and right now in the stock market, we are likely to see margin calls cause additional selling, which will lead many stock prices lower. The lower they go, the more investors will be tempted to throw in the towel and salvage whatever capital remains.
Volatility is an investor's nightmare
The sage investment advisors, people like Jack Bogle from Vanguard, are telling investors that this down move is speculative. Bogle always says that. He has SPY and many other passively managed ETFs to sell, so he makes a habit of regularly appearing on the news and telling everyone it is a good time to be long passively. Advisors like Bogle depend on the flow of funds into their mutual funds or investment programs for fees and commissions, and they point to factors that support their own vested interest that lower stock prices mean their clients can now buy at lower prices; stocks are cheaper than they were at the end of 2015. The fact remains, the current level of one-way volatility is an investor's nightmare and many will take protective action. Many will sell and abandon ship. That will add to the swoon in prices and that will eventually bring the stock markets to a level where buying actually makes sense. When it comes to many market experts, Daniel J. Boorstin, an American Historian who wrote on many topics in American and world history once said, "The greatest obstacle to discovery is not ignorance -- it is the illusion of knowledge."
Nowhere to run, nowhere to hide -- Deflation's bite
For those who have sold or are short, right now is a time to sit back. In their classic song The Ramones said, "Nothin' to do and nowhere to go-o-oh I wanna be sedated." Brother Bluto would tell those stuck in this bear market to drink heavily, and The Ramones would tell those who have liquidated positions or are short to stay sedated. The metaphor from both is, essentially, the same advice -- relax under these market conditions. Emotions are likely to get even the most seasoned investors and traders into trouble.
Current market conditions are difficult. As I look at my screen on Wednesday, January 20, I see a sea of red. The only assets moving higher are high-quality government bonds and gold. Oil is making new lows, metals are lower and the DJIA was just trading down over 500 points on the session. The slowdown in China, falling commodity prices, and now, a dramatic sell-off in equities has the distinct flavor of deflation. In a deflationary environment, the prices of all assets move lower. While gold is higher due to flight to quality or safe haven buying, that too can come under severe pressure in the current environment. The lower equity indices fall, the more margin calls, and that will mean that even assets that are performing well will need to be liquidated to raise cash to pay those calls. Deflation's bite is painful and that is what we are seeing at the beginning of 2016.
Stocks remain overpriced and panic has not set in, yet
These market conditions will invariably lead to high volatility. The VIX is rising and frenetic trading conditions are likely to remain in the weeks ahead. Markets love to take the stairs up; bull markets are generally slow and steady and occur over long periods. Bear markets are an entirely different story. Prices tend to take the elevator down. In early 2016, it feels like they fell off a roof. Generally, bear markets are close to lows when panic reaches an apex, when all analysts and pundits switch from soothing statements like "buy the dip" and "stocks are on sale" to sell everything and protect your capital. That has not happened yet nor will it until we are close to a bottom. Emotionally, that is the hardest time for an investor to step up to the plate and buy. However, over the course of history, those have been the best times to buy.
The stock market faces a severe problem at this time. Valuations were too high at the end of 2015, and they remain too high even after the bear market action over the first three weeks of the year. The P/E 10 ratio or Dr. Robert Shiller's Cyclically Adjusted Price Earnings Ratio (NYSEARCA:CAPE) was at 23.36 on Wednesday January 20. The long-term historical average is at 16.6. This tells us that on a historical basis, equity prices remain high even after the recent correction and the market could have significantly more room on the downside.
While we are seeing a great deal of concern about stock prices, we have yet to see panic. The odds of panic setting in have grown and the lower the market moves over coming sessions, the higher the chances that we see panic, which is an irrational response to events.
Cash is king -- Stay rational
Right now cash is king. Many are asking the natural question, where is the bottom in stocks? If you are asking that question, you are already in trouble. No one, even the best and most successful traders and investors, sells the highs and no one buys the lows. Rather, successful investing depends on a rational approach, which will result in re-entering the market when it stabilizes.
Attempting to try to perfectly sell absolute highs and buy absolute lows is a statistical improbability. Those who approach markets looking for perfect results either lose money or miss opportunities. The Carden Smart Hedge™ Index systematic signal switched to cash on December 11, 2016 when the S&P 500 index was trading at 2,012.37. That was not the highs. On Wednesday, January 20, the S&P 500 closed at 1,859.33 -- a decrease of 7.6%. The index remains in cash. The high degree of volatility coupled with falling knives is a good reason to avoid stock market exposure at this time. If you are out of equity exposure, good for you -- stay sedated until stability returns. The Carden Index will eventually respond to stability and yield a buy signal -- I can say with a high degree of confidence that signal will not come at the absolute lows. Meanwhile, if you are still long stocks, take some protection and start drinking heavily. The time will come when stocks fall to a level on a fundamental and technical basis where re-entry makes sense, but now is not that time.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.