The relentless push higher in the market is beginning to weigh on retail investors. However, as we have discussed several times recently, these advances, especially when driven by artificial influences, can stretch the markets to extreme limits along with investors patience. It is this final capitulation where retail investors “throw in the towel” with the belief that the market is not ever going to correct again. This, of course, leads to those poor emotional investing decisions that eventually lead to larger than expected portfolio losses.
For investors it is important to understand that the financial markets are not entirely devoid of basic physics. For example, when a ball is thrown in the air there are a few things that occur; 1) the rate of ascent decreases with the loss of momentum, 2) at the peak of the move the rate of ascent becomes zero and; 3) as the ball reverses course the rate of descent increases due to the force of the gravitational pull on the mass of the object.
The same principles apply to the market. As the market moves higher the rate of ascent decreases over a period of time. The moving averages, the 50-week moving average in our case study, provide the “gravity” to market prices. The further that prices move away from long term moving average the more pull, “gravity”, these moving averages exert. Historically, when prices have diverged more than 5% above the 50-week moving average, reversions have tended to occur. Today, the divergence is more than 6%. More importantly, when prices correct, or “revert”, back to the mean the rate of decline generally increases as function of the divergence from the moving average. This is why bear markets are generally much shorter in duration than bull markets.
If we look at our composite risk ratio indicator we can see that the markets are once again reaching extreme levels of bullishness. As a contrarian indicator its usefulness is to alert investors to extreme “bullishness” or “bearishness” in the market. You can see that in the summer of 2011 the markets had reached very negative sentiment which was a “bullish” indication for investors. In other words, as retail investors were panic selling to get out of the market – strategic investors were willing to buy into the market. The opposite is the case today which means that now is a better time to be a seller than buyer.
These “reversions to the mean”, or moving averages, always occur. Yet, as market prices rise or fall these “reversions” are disregarded by the media. Whichever direction the market is currently moving is extrapolated into the future with complete disregard as to how the markets have functioned repeatedly in the past. Like the ball being thrown in the air – the “gravity” exerted by long term moving averages will create a pull on prices back to, and generally beyond, the moving average which is why, after all, it is an average price. In order for a moving average to exist means that prices must have traded both above AND below that average price during the specified time frame. Prices cannot exist in a vacuum and are bound by these moving averages over time.
With the current market reaching extreme levels of bullish sentiment, more than 6% above its 50-week moving average and overbought conditions existing on just about every level the potential for a “reversion” process is very high. While a reversion may not happen today, tomorrow or even next week – it will occur. It is only a function of time and depth. For investors trying to save and invest for their retirement – to ignore this reality is to do so at your own risk and peril