Fear is Driving Stocks Down, or is Declining Stocks Driving Fear?

The last time I pointed out a short-term measure of extreme investor sentiment was August 4, see “Extreme Fear is Now the Return Driver“. At that time, popular stock indexes had declined -3% or more and as prices fell, investor fear measures increased.

As stocks rise, investors get complacent and brag about their profits. After prices fall, investor fear measures start to rise.

Since I pointed out “Extreme Fear is Now the Return Driver”, the Dow Jones Industrial Average went on to trend back up 5% by mid September. Below is a price chart for the Dow year to date. I marked August 4th with a red arrow. You can see how the price trend had declined sharply, driving fear of even lower prices, then it reversed back up. Fear increases after a decline and when fear gets high enough, stocks often reverse back up in the short term. They get complacent and greedy after prices rise to the point there are no buyers left to keep bidding prices up, then prices fall. Investors oscillate between the fear of missing out and the fear of losing money.

dow jones stock index year to date

Source: http://www.stockcharts.com

Since mid September, the price trend has drifted back down over 4% from the peak. As you can see, the Dow has made no gain for the year 2014. It is no surprise that investor sentiment readings are now at “Extreme Fear” levels, as measured by the Fear & Greed Index below.

Fear and Greed Index

Source: Fear & Greed Index CNN Money

So, the last time investor fear levels got this high, stocks reversed back up in the weeks ahead. However, it doesn’t always work out that way. These indicators are best used with other indications of trend direction and strength to understand potential changes or a continuation. For example, we commonly observe 4% to 5% swings in stock prices a few times a year. That is a normal range and should be expected. However, eventually prices will decline and investors will continue to fear even more losses. As prices fall, investors sell just because they’re losing money. Some sell earlier in the decline, some much later. You may know people who sold after they were down -50% in 2008 or 2002.  The trouble with selling out of fear is: when would they ever get back in? That’s why I manage risk with predefined exit points and I know at what point I would reenter.

My point is: fear always has the potential to become panic selling leading to waterfall declines. Panic selling can take weeks or months to drive prices low enough that those who sold earlier (and avoided the large losses and have cash available) are willing to step in to start buying again. Those who stay fully invested all the time don’t have the cash for new buying after prices fall. It’s those buy and hold (or re-balance) investors who also participate fully in the largest market losses.  It’s those of us who exit our losers soon enough, before a large decline, that have the cash required to end the decline in prices.

Selling pressure starts declines, new buying ends them.

We’ll see in the weeks ahead if fear has driven prices to a low enough point that brings in new buying like it has before or if it continues into panic selling. There is a chance we are seeing the early stages of a bear market in global stocks, but they don’t fall straight down. Instead, declines of 20% or more are made up of many cycles of 5 – 10% up and down along the way. So, we shouldn’t be surprised to see stock prices drift up 5% again, maybe even before another -10% decline.

Declining stocks drive fear, but fear also drives stocks down.

Let’s see how it all unfolds…

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