The stock market sold off sharply last week. Investors must now decide if they should decrease exposure to the equity markets. This is one of the most difficult decisions for an investor to make since it carries high risks, even though those risks might be hidden.
A decision to decrease exposure should include a decision to increase exposure again in the future. And, there are two parts to that decision to consider. Investors should determine how to increase their exposure to stocks if they are wrong and if they are right.
Facing Up to an Error in Timing
This could be the most difficult task for an investor. It’s admitting that the decision they made was not correct. And, they must decide if they want to fight the trend or get back into the market. The chart below provides an example of this problem.
This is the S&P 500 index in the late 1990s. This bull market began in 1982 and had seen just two brief declines of more than 20% in 1987 and 1991. Stocks had been overvalued for years and Federal reserve Chairman Alan Greenspan had famously described the market as a case of irrational exuberance.
In 1998, the news turned negative with economic problems in Asia. Emerging markets around the world faced a debt crisis and there were concerns that it could spread. Then, the S&P 500 fell below its 200 day moving average (MA). The chart shows the weekly price action and the equivalent 40 week MA.
Getting out of stocks in the summer of 1998 could have felt good. But, the S&P 500 would go on to gain more than 30% in the next two years before topping. This is shown in the next chart.
That’s the problem with reducing exposure to the stock too early. Missing potential gains could have a large impact on the amount of money available in retirement. The bottom line is that few investors can afford to miss out on a gain of 30%.
This shows the danger of selling too soon. This also shows why investors need a plan and most importantly they must have the discipline to stick with the plan, even when it is uncomfortable to follow the rules.
Buying In After a Decline
Another problem for the investor who reduces exposure to the stock market is what to do if they are correct and stocks sell off. To see how this problem can develop, try to think back to March 2009.
That was a time when the economy seemed to be falling off a cliff and the global financial system was in chaos. Stocks were selling off sharply as the next chart shows. This is the S&P 500 again and it was more than 50% below its highs.
The Federal Reserve was introducing new programs to boost the economy. Some analysts believed the idea of quantitative easing was an act of desperation and showed how dire the situation had become. Few analysts expected the stock market to recover quickly.
Could you have bought stocks at that time? We now know that was the bottom. But, at the time, which is the time when a decision must be made, it may have been difficult to act. Fear was the most likely response to what had happened in the stock market.
But, that was a time to buy as the next chart shows.
Now, on all of the charts, we have included the 40 week MA. The charts show that following this indicator – selling when the price of the index closed below the average and buying when the price closed above the MA – could have been better than doing nothing.
A Plan for the Current Market
The 40 week MA certainly isn’t a perfect market timing tool. There are a number of whipsaw trades with this indicator.
Whipsaw trades are defined by Investopedia as “the movement of a security when, at a certain time, the security’s price is moving in one direction but then quickly pivots to move in the opposite direction. There are two types of whipsaw patterns.
The first involves an upward movement in a share price, which is then followed by a drastic downward move causing the share’s price to fall relative to its original position.
The second type occurs when a share price drops in value for a short time and then suddenly surges upward to a positive gain relative to the stock’s original position.”
These trades are frustrating but successful traders have the discipline to act on signals even after a series of whipsaws trades.
To trade the current market, and prepare for the bear market, investors could use a long term MA. They could also use a momentum indicator such as the stochastics on a weekly chart or the MACD on the monthly chart.
These indicators rarely offer signals as the chart below illustrates. This is a chart of MACD applied to monthly data.
But, the signals will almost certainly put investors on the right side of every long term trend in the stock market. The signals will also offer guidance for times when markets appear to be topping or bottoming and the signals will avoid paralysis in the face of a fast moving market.
No matter which indicator you choose it must be followed with discipline.
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