Recently, the financial markets have become very jittery. Stocks have been experiencing intraday fluctuations of up to 5%. I call this a panic, because it demonstrates that investors are freaking out. So how do you invest when the stock market is in a panic (the opposite of a bubble)?
Any panic, like any bubble, has 3 parts. Beginning, middle, and end. Simple as that.
Beginning – Markets start getting jittery.
The beginning stage of any panic (one or two year big bear market) begins when the markets start stalling, and get jittery. Previously there had probably been a bull market, but now, investors are reconsidering the the stock market. The investment clouds are coming. The smart investors start selling here. People begin to think “maybe the stock market shouldn’t be going up.” Investors start becoming a little nervous at this point, because data is showing that the economy is stalling, and corporate profits aren’t doing as well as people expected them to be.
So how do you invest in the beginning stage of a panic? The question that I ask every time the stock market stalls is “Is this just a temporary pause, or is this the real deal? Is this really the end of the bull market, and the beginning of a bear panic?” To tell the truth, most people don’t know. I don’t know either. Only those who have serious connections can know this stuff, because information favors the rich and powerful. My advice at this point? Go all cash. If the markets are just taking a temporary break, then it would do no harm to buy back into the markets when you see technical indicators indicating that prices will go higher. If, however, this truly is the beginning of a bear panic, then at least you’ll conserve your investment capital.
Middle – Volatility really increases, and investors are frantic.
The second stage of a panic is when prices have slowly declined a little from their peaks, and now, panic is in the air. Investors are getting really afraid, because they don’t know what to do! Volatility increases, and intraday price fluctuations are often in the 3-6% range. This is because investors are really uncertain. They don’t know if the real, big decline is coming, or if they should buy in on the now “undervalued” prices. A good example of this was in October 2008, when the financial markets were entering the second stage of a panic.
However, in this stage, the smart and sophisticated investors have already gotten out, leaving the suckers to stay in the market. The sophisticated investors look to a few things to see whether a major decline is coming.
The economy. If the economy is stalling and falling, then there’s a good chance that a bear panic is coming. But not always.
The Fed. Sometimes, when the economy is performing poorly, stocks can still be flying high. This is because the Fed is purposely propping up stocks to make the economic picture seem nice and rosy.
What other investors are doing. The smart investors understand that investing is a game of psychology. One needs to know how others will react to the markets, even before the others themselves know!
My advice on how to invest in the middle stage of a bear market? Short the market with 70% of all your portfolio, and make sure that your shorts are medium term. I once wrote in a post titled Common Mistakes Made by Investors that shorts should be short termed, because timing is everything. But that case no longer applies now. If you short the markets on a short term basis now, then prepare for a speed ticket to the poorhouse. Because there is so much volatility at this stage, and no one can predict whether the stock market will go up 5% today or down 5% today, short term shorts down work. But make sure to hang onto your crocks and socks, because the volatility truly can be mind blowing. Don’t change positions very much, or else you’ll be wiped out by the volatiliy.
Final stage – sheer panic.
So how do you know when the final stage of the great bear market is coming, when you can close your shorts and cash out at a handsome profit? I would like to change Warren Buffett’s statement from “buy when others are fearful, and sell when others are greedy” to “buy when there is complete panic in the markets, and sell when utter euphoria is taking place.” If you had followed Buffett’s advice, then you would have bought when the panic was in it’s middle stage (in other words, gotten taken to the financial cleaners). The final stage is when sheer panic takes place. There is no longer ANY rational logic left in the market. The smart and sophisticated investors have already gotten out or gone short (or long if they believe the panic is about to end, and a bull market is ready to ensue), and what’s left are the masses of moms and pops who are wishing to sell out their portfolio at already extremely depressed prices.
So my advice? Cover your shorts by 20% every time the market moves down 5%. Once you’ve completely closed your shorts, buy 100% into the markets. But make sure you hang onto your longs (now is the time that buy and hold works!), and don’t buy individual stocks. Individual stocks have the chance of going down to zero, while if you buy the whole market (e.g. SPDR Dow ETF), there is no chance of that investment going down to zero because it’s simply not possible for every stock on Wall Street to go bankrupt.