Trading Stock Fear 2

By: Adam Hamilton | Fri, Aug 12, 2011
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With the plunging stock markets terrifying traders, many are running for the hills. Steep selloffs always generate intense fear, a scary emotion from which we humans are naturally hardwired to flee. But in the stock markets, major fear spikes should be embraced. They mark the best opportunities ever seen to buy low, the necessary prerequisite to selling high and multiplying your wealth.

The ideal time to buy low is when everyone else is selling, and we have seen that in spades over the past couple weeks. The flagship S&P 500 stock index (SPX) plunged a brutal 16.8% in only 11 trading days. Well over a third of this selloff was condensed into a couple seriously-nasty ones. On Monday alone, the biggest and best American companies represented by the SPX collectively plummeted 6.7%!

This bloodbath ignited a massive fear spike, with frightened traders predicting a new recession and panic-like cascading selling. While the plunging markets made all these scary prognostications seem rational, they were anything but. Traders and the financial media always shape and spin newsflow to rationalize whatever emotions they happen to be feeling. Scary price action drives scary newsflow.

Short-term stock-market action is not driven by fundamentals like corporate earnings and economic data, but by greed and fear. After a long rally, greed waxes too extreme leading to stock prices getting too high and overbought. From such conditions corrections are born, as I warned back in mid-April as the SPX approached its post-panic highs. Unfortunately these dangerous times are when most traders want to buy.

Then after corrections, fear mushrooms to blinding intensity which drives stock prices to irrationally-low and oversold levels. This is exactly what we saw this week. Out of these bleak episodes, huge rallies are spawned. The best time to buy low is when the thundering herd is convinced the stock markets are ready to plunge off a cliff. The resulting bargains are incredible, the lowest prices seen in any ongoing bull.

Trading fear is the easiest and surest way to earn a fortune trading stocks. But first this ethereal emotion must somehow be quantified. While fear can't be measured directly, it can be inferred through sentiment indicators. My favorite is the venerable old-school VIX, the S&P 100 implied-volatility index now known as the VXO. It measures the implied volatility of at-the-money options expiring one month out in the biggest, most-liquid, and most-responsive stocks of the S&P 500 (its top 20%).

This proxy for fear is far superior to today's VIX, a bastardized version hatched back in September 2003. Even though it is the biggest and most-liquid stocks that are sold fastest in a selloff, today's VIX includes the entire S&P 500 which is much less responsive than its leading S&P 100 companies. Even though at-the-money options prices move fastest in any selloff, today's VIX is diluted with out-of-the-money options. What passes for the VIX now is inferior and sluggish compared to its original namesake, today's VXO.

Whenever this decades-old VXO surges rapidly to high levels, it signals excessive and unsustainable fear. While powerful, this emotion is finite. Eventually everyone who is going to be scared into selling by falling prices will have already sold, leaving only buyers. And at that exact fear climax is right when the biggest rallies ever seen in the stock markets suddenly ignite. Riding them yields enormous profits.

While this buy-fear-sell-greed truth extends back through all of financial-market history, I'm going to focus on just our current cyclical bull today. It was born out of extreme fear back in March 2009, a time when everyone was convinced we were on the verge of a new depression after 2008's epic stock panic. But between that very despair and late April 2011, instead the flagship S&P 500 soared 101.6% higher in a mighty cyclical bull. Like all bull markets, this one experienced periodic selloffs to rebalance sentiment.

VXO and SPX 2009-2011

All of these major periodic selloffs are labeled in this chart, divided between pullbacks and corrections. Pullbacks are smaller stock-market selloffs of less than 10%, while corrections exceed this threshold. Far from being the threat they're always perceived to be at the time these selloffs occur, they're essential for a bull's health. They prolong bull markets by bleeding off excessive greed and rebalancing sentiment.

Note that every single pullback and correction of this entire cyclical bull witnessed a parallel fear spike as evidenced by the surging VXO. Naturally the degree of fear varies proportionally to the magnitude and sharpness of the SPX selloff. Bigger and faster selloffs ignite more-intense fear than smaller and milder ones. Nevertheless, all saw significant fear spikes as measured by the definitive VXO fear gauge.

The biggest fear spike of this entire bull, before this past week's brutal selloff, erupted in the summer of 2010. It started in May 2010 with the infamous Flash Crash, a crazy 4.5% SPX plunge in 5 minutes. This selloff grew into a full-blown correction in which this flagship stock index surrendered 16.0% in about 10 weeks. This drove the VXO as high as 43.6 mid-correction, and 33.8 by the time it had run its course.

Now you may not remember just how bleak things looked last summer after this major stock-market correction. Big mainstream financial news was an obscure but notoriously-unreliable indicator ominously named "the Hindenburg Omen". Traders universally feared another panic, an irrational belief I attacked right at those depths of despair. And what happened after those scary lows of last August? The SPX soared 30.2% higher by late April 2011! Fear should be aggressively bought, never sold.

Go back and read financial news and commentary from July and August 2010 after this cyclical stock bull's first correction. What the heck were traders so worried about then? The same things we heard this week! A slowing US economy as well as the endless European sovereign-debt woes and default threats dominated psychology at one of the best buying opportunities of this entire bull market. Traders caught up in this irrationally-pessimistic newsflow, cowering in cash, missed a wildly-profitable upleg.

Now today we find ourselves in the second correction of this bull, a 17.9% SPX decline over 14 weeks that is roughly the same magnitude as summer 2010's 16.0% over 10 weeks. This steep selloff has dredged up the same old slowing-US-economy and European-sovereign-debt fears. Traders are scared, with the perma-bears, pessimists, and chicken littles doing their best to convince everyone a new stock panic draws nigh. And look at the resulting fear spike, it is utterly massive!

Prior to today's ninth major selloff of this cyclical stock bull, the average VXO peak within a couple trading days of the SPX's bottoms was 28.3. With the exception of the only other full-blown correction last summer, this level of fear was sufficient to temporarily bleed off greed and rebalance sentiment. But this week on Monday's brutal 6.7% SPX plunge, its biggest down day since December 2008 in the heart of the stock panic, the definitive VXO fear gauge skyrocketed 50% higher to close at 49.4!

The more extreme fear gets, the more compelling the buy signal. After every other pullback and correction of this entire bull, the SPX rallied sharply as you can see in this chart. And all of these other fear spikes except the other correction's were relatively minor. A 28ish VXO is nothing compared to a 50ish one, the fear isn't even in the same league. A 50ish VXO is inarguably, absolutely extreme fear!

It brought back some fond memories for me. Nine years ago this very week, I wrote my first essay on the VIX (today's VXO). Called VIX Bounces S&P 500, it chronicled how 50ish VIX reads absolutely marked major bottoms and the highest-probability-for-success buying opportunities ever seen in bull markets and bear markets alike. You will never get a better, surer buy signal than a 50ish VXO, it is the pinnacle! So naturally we aggressively plowed capital into radically-oversold commodities stocks this week.

Now there is one exception to this 50ish VXO ceiling, and that is panics and crashes. If we are heading into a panic or crash as popular sentiment suggests, the VXO can temporarily surge a heck of a lot higher than 50. Back in October and November 2008 during that epic stock panic, the VXO skyrocketed up into the high 80s! So should contrarian investors and speculators prudently buying extreme fear worry about a new stock panic or crash anytime soon? Definitely not.

Panics and crashes are very specific and exceedingly-rare events. A panic is a 20%+ plunge in the stock markets in a matter of weeks that only occurs out of lows late in cyclical bear markets. But we are not late in a cyclical bear today, we've been in a cyclical bull since March 2009. Panics cascade out of bear-market lows, but we weren't far from bull-market highs when this latest selloff started. These events are never seen close together either, 2008's was the first true panic since a century earlier in 1907!

Just as panics only occur at one specific point in bull-bear cycles, so do crashes. They are 20%+ plunges in the stock markets in a matter of days, and only erupt out of multi-year highs deep in secular bulls. We are not only in a secular bear today, but this latest selloff started accelerating from well under late April's SPX highs. The cycles are all wrong for another crash today too, it isn't going to happen.

These bull-bear cycles are incredibly important to study, as knowledge of them and the Long Valuation Waves that frame them is absolutely critical to long-term investing success. Expecting a panic or crash at the wrong place in these cycles is like predicting an epic blizzard in July. No matter how much people fear snow, a wicked snow storm simply can't exist outside the bounds of the seasonal cycles.

And panics and crashes create such immense fear that they are effectively once-in-a-generation events. It takes decades to build enough complacency and greed to fuel such epic selling events. They are like massive wildfires. You can't have a huge once-in-several-decades wildfire just several years after the last one. There simply isn't time for enough new fuel to grow back in. Expecting another panic so soon after 2008's is like expecting an epic wildfire in an area thoroughly burned out just a few years earlier!

Despite this, after every major correction people irrationally expect a panic or crash. These big selloffs frighten them so much that they sell near lows, so they need to cling to some theory to rationalize their poor decisions. Thus fears of a panic or crash are simply another bottoming indicator, an aspect of any large fear spike that helps define incredible buy signals. I'd be concerned if panic, crash, recession, depression, new-bear, and sovereign-default talk didn't exist today!

That new-bear thread is worth pondering. Every correction sees intense fear that a new cyclical bear market is being born. This is certainly possible today, but not probable. Back in late June I wrote an entire essay showing in bull-bear-cycle terms why a new cyclical bear isn't likely today. While a new bear is a vastly-higher probability than a panic or crash, it is still too low to worry about right now. During summer 2010's correction new-bear fears flourished too, yet look at the mighty SPX upleg since.

Buying fear, being "brave when others are afraid" as Warren Buffett sagely articulated, is the surest way to buy low in the stock markets. Fear leads others to sell, which drives stock prices down to irrationally-oversold levels totally disconnected from their core earnings fundamentals. If you can steel and harden yourself to fight your own fear, to buy when you least want to, you can capitalize on these awesome bargains.

While a 50ish VXO is effectively an absolute ceiling on stock-market fear except in once-in-a-generation panics and crashes, I also like to look at fear in relative terms. VXO 50 approaches are so darned rare that many years ago I had to figure out a way to grade lesser fear spikes. I needed a shorter-term baseline for fear, and settled on the VXO's 200-day moving average. I used my highly-profitable Relativity Trading system to quantify the VXO as a multiple of its 200dma. Over time this forms a horizontal trading range.

Relative VXO 2009-2011

The raw VXO is rendered in blue here, slaved to the right axis. The Relative VXO, or rVXO, is shown in light red on the left. Over the past 5 years or so, this VXO-divided-by-its-200dma multiple has tended to oscillate in a range between 0.75x on the low side to 1.75x on the high side. When the VXO slumps to 75% or less of its 200dma, odds are fear is too low (therefore greed is too high) so an imminent pullback or correction is likely.

Conversely when the VXO soars to 175%+ of its 200dma during a stock-market pullback or correction, the odds grow overwhelming that fear is too extreme to be sustainable. Every SPX pullback and correction from the first chart is also numbered on this VXO chart, along with the rVXO reads near their bottoms. Note that at an insane 2.75x its 200dma this past Monday, we've just seen the highest relative fear reading of this entire cyclical bull!

The more extreme any fear spike, the greater the odds it is unsustainable. And the selloff that drove it is effectively over since everyone susceptible to getting scared into selling anytime soon has already sold. The last time we saw such wild 2.75x rVXO readings was back in October 2008 in the heart of the stock panic, right before the SPX soared 18.5% in just over a week in a monster bounce rally!

Whether you want to measure it absolutely with the 50ish VXO ceiling or relatively compared to its 200dma, fear as measured by the VXO was off-the-charts high this week. Such extreme fear is never sustainable, it almost instantly burns itself out like a flaring match head. Super-high absolute or relative VXO reads simply have to be bought aggressively. Extreme fear drives irrationally-low stock prices, but these incredible bargains are very fleeting.

While I certainly didn't expect a massive 50ish VXO spike or the brutally-fast SPX plunge necessary to spark it, I was warning in mid-June in my original Trading Stock Fear essay that a big fear spike was overdue. And only a full-blown stock-market correction could spawn it. So while the exact magnitude of any fear spike is unpredictable, they do occur with some regularity as healthy pullbacks and corrections periodically rebalance sentiment. Coming out of a low-fear environment, a fear spike should surprise no one.

After a quarter century of trading stocks, I know exactly how hard it is to battle the greed and fear in my own heart. Being a contrarian, being brave when others are afraid and afraid when others are brave, is very challenging. It is stressful and wearying to fight the herd, to do the opposite of what everyone else thinks is prudent at the time. Yet it is worth every ounce of angst because the rewards are so high.

At Zeal, we've been buying fear and selling greed publicly for over a decade now. Since 2001, during a sideways-grinding secular stock bear no less, all 591 stock trades recommended in our newsletters have averaged annualized realized gains of +51%! We didn't achieve this by buying high when it felt good and selling low when everyone was scared, but by doing the exact opposite. Contrarian trading is the only way you can grow your capital at 50%+ per year, which multiplies your wealth at a dazzling rate.

And after realizing huge profits earlier this year as the SPX hit new highs, we have again started buying aggressively. In the past couple weeks alone, we've added 14 new stock trades and 4 new options trades in our newsletters! If you can muster the courage to buy fear, if you want to thrive in these stock markets, subscribe today to our acclaimed weekly or monthly newsletters! In them I explain what the markets are doing, why, and where they are likely heading next. You can mirror the actual trades we are making.

The bottom line is this past week's stock-market plunge ignited incredibly-intense fear. The definitive fear gauge skyrocketed so high that it slammed into its effective ceiling in normal market conditions. Such extreme fear is absolutely unsustainable, as it scares all the weak hands out of the markets and burns itself out. But it drives stock prices to absurd hyper-oversold levels, creating incredible buy-low bargains.

Sadly, the great majority of investors and speculators haven't trained themselves to fight the crowd. Instead of buying low in extreme fear, they sell low. Then they stay out until long after the markets have rallied dramatically, only belatedly returning to buy high. It is only the contrarians, the wise minority that have hardened and steeled themselves to trade fear rationally, that buy low, sell high, and earn fortunes.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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