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Complacency in the Stock Market

Summary

  • Emotions are the greatest force that drives the markets
  • Extreme fear has historically accompanied major market bottoms
  • Extreme greed combined with complacency have historically been present at market tops
  • A prudent money manager will look for extreme fear to buy and high levels of complacency to sell or go defensive.
  • After starting 2009 in extreme fear we entered into 2010 with a very high level of complacency
  • Because the market became overly complacent early this year, we made moves to go defensive
  • We believe the potential downside risk is greater than the potential upside gain.
  • Going forward we will remain defensive until the market presents better opportunities

com·pla·cent
–adjective
1. pleased, esp. with oneself or one’s merits, advantages, situation, etc., often without awareness of some potential danger or defect;
(dictionary.com)

“For the waywardness of the simple will kill them, and the complacency of fools will destroy them;”
– Proverbs 1:32

“When a great team loses through complacency, it will constantly search for new and more intricate explanations to explain away defeat.”
– Pat Riley

How Fear and Greed Drive the Market
Many analysts, academics and economists will tell you that markets make moves in certain directions because of “Fundamentals” (earnings growth, economic trends, etc.) and/or “Technicals” (momentum, money flow, breakouts, etc.).  To some degree they are correct, but in my opinion the greatest force that moves the markets are the emotions of fear and greed. Both fear and greed are huge motivational factors in the market.  In general, fear will cause people to sell and greed will cause them to buy.  Extreme fear is usually accompanied by panic and historically that is when market bottoms are formed. This phenomenon occurs because massive amounts of people will capitulate (surrender) and sell regardless of the price, at which point the supply of sellers will virtually dry up leaving very few people left to sell.  Wise institutional investors will take advantage of this rare moment and buy shares at extremely low levels.  Then, the rest of the market will follow once they see prices rising providing a significant level of demand that will give the market a sustainable amount of buy orders (demand) in order to push the market up for a long period of time.  An example of extreme fear would have been in late 2008 and early 2009.  It was no coincidence that a significant bottom was formed during that time and a great buying opportunity occurred.  On the other hand, extreme greed is usually accompanied by complacency or a lack of fear that the market will fall. Extreme greed and complacency historically mark market tops.  Extreme complacency will cause the market to be vulnerable because virtually everyone believes the market will go higher so everybody would already be invested leaving very little potential demand of new buyers. Conversely this leaves an abundance of potential sellers (supply).  An example of extreme greed was in late 1999 or early 2000 when the majority felt that they had to buy into stocks and there was little fear of the market falling.  A prudent money manager will look for extreme fear to buy and high levels of complacency to sell or go defensive.

After starting 2009 in extreme fear we entered into 2010 with a very high level of complacency.   Even after going through the worst bear market since the “Great Depression” you would think that the majority of people would still be recovering from the massive scars that markets left them with in 2008.  Although, admittedly not everyone feels like the economy is on sound footing, according to most indicators that measure sentiment the market became very complacent in early January and still has a high level of complacency considering everything that we just went through over the last couple of years.  The main way that we measure complacency and fear is by looking at the CBOE Volatility Index (VIX).  Historically, when the indicator is high (above 40) it is considered extreme fear and when the indicator is low (below 20) it’s considered a high level of complacency.  In (Figure 1) below you will see that when the VIX hits high levels above 40 the market has bottomed and when the VIX goes below 20 the market has topped.


(Figure 1)

Our Recent Market Moves
Because the market became overly complacent early this year, we made moves to go defensive and take profits on many of our positions that we bought in late 2008 and early 2009.  In our actively traded accounts we now hold about 40-50% of the entire portfolio in cash.  Plus we’ve bought into long-term government bonds as a hedge against a falling market.  Long-term government bonds are considered a safe haven play.  I know that may be hard to believe because of our large government deficits and high amounts of government debt, but it is true still to this day.  In fact, in 2008 when the market was down nearly 40%, long-term treasuries were up over 30% for the year.  In our strategically allocated accounts I have increased some cash, but mainly we have transitioned a portion of the riskier assets like commodities, emerging markets, international equities and small caps over to more domestic value stocks and other traditionally more stable areas. Similarly we have transitioned our bond portfolios from riskier funds into traditionally safer areas.  The moves were made because of the potential market pullback.  Certain factors historically point towards a more aggressive investment position, a good example would be early 2009 when stocks were at decade lows and there were extreme levels of fear and other circumstances point towards a defensive posture, like the beginning of this year when some stocks indices had rallied over 70% or more in a matter of 9 months.  After the market has moved that much to the upside in that short of time combined with a high level of complacency there is cause for concern which is why we went defensive.

Strategy Going Forward
We plan on remaining in a defensive posture in the attempt to preserve wealth and to be ready for when the market pulls back.  We will attempt to wait for high levels of fear in order to purchase equities at lower prices than what they are going for now.   If the market pulls back as anticipated, we will be ready to put some of the cash back to work.  But for now we believe the potential downside risk is greater than the potential upside gain.  So we will remain defensive until that environment changes.  A wise money manager will always try to target a greater amount of potential gain than what they are willing to risk and currently those opportunities are not readily available. Once they become available we will try and take advantage of them again.

Allgen’s Investment Approach
Allgen specializes in active money management.  Through technical and fundamental analysis, along with a contrarian mindset, we strive to navigate the markets during periods of prosperity and/or decline.  We constantly research and study the markets to find the next emerging area even in asset classes that are typically not used in your “buy and hold” asset allocation portfolios.  During the good times we focus on strength, and during the bad times we try to preserve wealth. During periods of stagnation, such as we are experiencing now and potentially years to come, we see ample opportunities to take advantage of this market.  If you want to see how active money management may fit into your overall investment portfolio then please email us advisors@allgenfinancial.com or give us a call at 1-888-6ALLGEN (625-5436).

Written By:
Jason Martin, CFP®, CMT
Senior Partner & Chief Investment Officer
Allgen Financial Services, Inc.
martin@allgenfinancial.com