Kyith: I wrote this article probably 4 years ago in Aug 2014, when the market was a little volatile and that readers require some guidance.
Since this week there are some volatility in the markets, I thought I will let you guys read this again. The last segment contains some rule of thumb for buying. If you are interested let me know about bringing back some post on distress buying.
We haven’t had good volatility for a few months. Such is the bullish nature about the markets that there was a long streak where the S&P500 did not experience more than a 1% drop in prices. It is significant considering watching the markets for 10 years that I did not see a phenomenon like such.
And so we have recent distress in the markets that we finally see some drawdown in prices. Since the high of 1990 we end up with prices at 1909. This is a 4% draw down.
The magnitude of the draw down isn’t fascinating for me since in 2011 we seen bigger drawdown’s nearer to 16%.
What is fascinating is how the general narrative of the public to such a draw down.
I wonder should the magnitude get to 10%, what the general public will be thinking. Will they be thinking “We are at the start of a 50% bear market!” or “This is just a mere correction!”
It is likely to indicate whether there are any recency bias to bad memories that people are facing:
Think about this from the standpoint of an investor. The market falls 50% in 2008 and early 2009. That hurts. Then it rallies 130% over the next few years, recouping all of your losses and then some. This feels OK, but not nearly good enough to ease the shock you felt from the 50% crash, which was emotional and memorable. You remember the crash much more vividly than the ensuing rally, and you change your portfolio to make sure you never suffer through a crash again. You buy bonds, hold a lot of cash, and swear off stocks for good. We’ve seen quite a bit of this behavior over the last few years. And we know it comes at the expense of long-term performance.
The problem is that we could be at the dawn of a new structural bull market, if the general narrative or psychology is still closer to that of “this is the start of the 50% plunge!”.
A structural market is usually built on these unbelievable sentiments, whether it is positive or negative. I felt that if sentiments are closer to “this is a mere correction”, it is that people are finally getting past that we are not going to see another 2008 plunge again.
That might not be truly negative, but I felt it is a point where complacency sets in.
And there are many possibilities that complacency has set in. People are often their worst enemy and likely to have the courage to be a long term investor when things are looking good, and there are many positive news. That is when they deploy more cash. Which they should be inverting. So that is usually a good contrarian indicator.
Equity allocations among individual investors reached their highest level in 6 1/2 years last month, according to the December AAII Asset Allocation Survey. At the same time, fixed-income allocations fell to their lowest level in 4 1/2 years and cash allocations fell to a three-year low.
Stock and stock fund allocations rose by 4.1 percentage points to 68.3%. This is the largest allocation to equities since June 2007, when stock and stock fund allocations reached 68.6%. December was also the ninth consecutive month, and the 11th out of the past 12, with equity allocations above their historical average of 60%.
Bond and bond fund allocations fell 2.1 percentage points to 15.2%. This is the smallest fixed-income allocation since May 2009, when bond and bond fund allocations were 14.2%. December was also the first time in the past 54 months when fixed-income fund allocations were below their historical average of 16%.
Cash allocations fell 2.0 percentage points to 16.5%. This is the smallest allocation to cash since November 2010, when cash allocations were 15.9%. December was also the 25th consecutive month with cash allocations below their historical average of 24%.
Judging by how highly correlated cash levels and precursor to drawdowns, this should amount to something. But how you view a picture is a matter of perception. That picture should scare the shit out of you.
On closer inspection, you can can observe a few drawdowns that are more correlated to extremely low cash levels, THAT didn’t end up as a large draw down.
What Matters to You
What matters at the end of this, whether it is a correction or a large draw down, is that you probably won’t know the magnitude.
You probably don’t know how long it will last.
If you based your wealth building on knowing that, then good luck to you.
For all things, you have to ensure that your wealth building process is fundamentally sound, and you have a good systematic plan for it.
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