The New Reality of Fear and the Year Ahead

By: Clif Droke | Mon, Dec 26, 2005
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In the late 1990s I was living in the Washington, D.C. metro area. The roaring '90s bull market was in full swing with stock prices shooting to greater heights each day and economic growth was booming. The news media never tired of reminding us how the "white hot" sales and productivity growth was evidence of a fabulous "New Economy" that would last forever.

Each morning I would walk to my office in the city and would always pass by a couple of newspaper racks, one for the Washington Post and the other for USA Today. I'd make a point of always scanning the top fold of the paper on display in the racks before deciding whether to invest my 50 cents for the day's news. Invariably, I'd end up forgoing the morning newspaper since the front headlines rarely stoked my interest.

The news headlines of those days were downright boring. As a student of journalism, I noted that the news headlines of the late '90s were everything a headline shouldn't be. Instead of focusing on the many problems I knew were brewing under the surface of the financial markets and economy at that time, the news media was content to focus on what was seemingly right instead of investigating behind the scenes as every good journalist would do. (No excitement equals no sales in the news business, so it wasn't surprising to see newspaper sales decline during that period.)

But the point I'd like to emphasize here is that the media deliberately chose to focus on the good times instead of on the worrying undercurrents of those days. Fear was a non-entity in the Roaring '90s and you'd go a long way before you ever came across a fear-laden news headline, especially one concerning the economy. This led me to the conclusion that runaway bull markets are "boring," particularly in the final stage of ascent when the crowd is most inclined to throw caution to the wind and embrace the ebullient spirit of the times.

Where newspaper headlines attract the most attention is in bear markets, and especially in the 2-3 years following a major bear market. According to behaviorists, this owes itself to the tendency of the mass mind set to be, on average, at least two years behind the trend with its lagging emotional response curve. Newspapers more or less reflect the trends that have already long been established and it's only when the point of "mass realization" sets in that headlines become emotionally responsive to the prevailing trends.

In contrast to those giddy and forward-looking headlines of the late '90s, the mainstream news stories of the past 2-3 years have tended to be much more pessimistic and backward-looking (in the sense that these "news" stories focus the attention of the target audience to the bearish events of the past three years, such as bombings, wars, bear markets, and other negative occurrences). Without stretching the truth very much one could well characterize 2004-2005 as "years of fear" in reference to the reporting slant of the mainstream press.

Without even going out of my way, here is a small collection of headlines I've assembled from just the past week as they've leapt out at me from the MSN newswire:

"New sober worm expected to hit Jan. 5"

"Be prepared for shocking energy bills this winter"

"Coastal residents fear next hurricane season"

"Plan meets with fear, anger"

"New warning on nuke terror"

Then there is the media's constant warning to consumers to beware of credit card fraud and identity theft. "Officials warn shoppers of credit card fraud" said once recent headline. But on that same day and on the same news service the following headline appeared: "Checks: A Thief's Best Friend (How a piece of paper can be a ticking time bomb)." It seems the poor consumer just can't win -- doomed if he uses credit cards, doomed if he writes checks.

Fear-related themes have been common since 2004 and have continued through 2005. The fear was much more palpable in 2004 than in the past year, however, as the extremely large assemblage of headlines clipped from the Financial Times newspaper attests (which I call a "fear collage"). The headlines of 2005 weren't always as gloomy and overtly fear-laden as the ones of 2004, but the fearful/pessimistic undertones were definitely there throughout the year. Even the natural disasters of the past year served to bolster this undercurrent of fear.

The Decennial Cycle

A discussion of the well-known "Decennial Cycle" (not to be confused with the Kress 10-year cycle) made famous by Edgar Lawrence Smith in his classic tome, "Tides in the Affairs of Men" is in order.

The fifth year of each decade tends to exhibit the most latent fear in public sentiment. This is perhaps one reason why the stock market tends to do so well during the fifth year since the market responds favorably to investor fear. But since fear and worry characterize the middle part of each decade (partly due to the 10-year cycle that bottoms at the end of the fourth year of each decade), it also means consumers are less likely to splurge on discretionary and luxury items as they so often do during the later part of the decade. Indeed, the fifth year often sees retail sales weaken, an increase in apartment and commercial office vacancies, job market softness with some economic sectors getting hit harder than others. (As one recent holiday sales headline reported, "Malls full but sales not spectacular").

The sixth year of the decade usually sees at least one spirited and extended rally develop, which is largely fueled by the fear that has built up in the investing public during the preceding years. It's in the sixth year that the public becomes at least slightly less cautious and, casting its fearful tendencies aside, start buying again. The sixth year usually sees at least a partial "pay-off" from the reluctance of the public to commit to stocks in the fourth and fifth years.

As the realization slowly sinks in that stocks have risen for the past 2-3 years (bear markets being most common in the early part of each decade), the more perceptive segment of the public will start testing the waters in the sixth year of the decade, just as they did in 1976, 1986 and 1996. The market manipulators now have a permanent built-in fear factor to keep the broad market buoyant in the foreseeable future. This will help repair the famous "Wall of Worry" that every stock market needs in order to climb.

Revenge of the fence sitters

Shortly after the 2000-2003 bear market ended, it became noticeable that the percentage of investors classifying themselves as "neutral" in the weekly AAII investor sentiment survey began expanding rapidly. In prior years, the neutral reading hardly ever became a factor of investor psychology with most of the useful contrarian readings coming from either the excess of bullish or bearish investors. But the "neutrals" have been a dominant force in the market at various times during the past three years. There have even been times when the percentage of neutral investors have outnumbered even the bulls and the bears. The tendency to run to the side lines whenever the market drops or moves sideways for any length of time is the new reality of our time. It can usually be interpreted through a bullish lens (from a contrarian standpoint) since it normally results in the market turning upward whenever the neutral percentage grows to a conspicuous level. Thus we see that the memory of the previous bear market of 2000-2003 is still strongly etched in the collective memory of the investing public. The mere hint of falling prices since that time has been sufficient enough to move them heavily to either the sidelines (i.e., "neutrals") or to the bearish camp. And in either case the market always responds favorably by resolving itself to the upside once the fear increases.

Oil and gold as barometers of fear

The oil price itself has become an important barometer of fear in the investment world. So has the price of gold. Whenever the prices of these two important commodities rise in sustained fashion it is at least in part in response to fear; it's also a major cause of fear in the investing public. The reaction to rising oil and gold prices in the Wall Street press is a testimony to this. Longer-term upward momentum in these key commodities will actually serve as a catalyst to keep the stock market, and by extension the broad financial system, buoyant through the difficult years ahead.

Wars and the market

Wars, bombings and blood in the streets is a major underpinning of a strong market. As sullen as that statement may be, it is nonetheless a proven observation. During periods of intensive military struggle or even terrorist bombings in various parts of the world, the stock market tends to respond favorably toward the bulls by moving higher, or at least remaining buoyant. Wars, bombings, revolutions and general "blood in the streets" is very much a part of the fabled "Wall of Worry" we've all heard about. That is to say, the market responds favorably in a milieu of violence. It's during times of extended "peace and safety" that the market doesn't like, which is one reason why wars are crucial to keeping bull markets alive for any length of time.

Conclusion

The year 2006 we're entering is a post-fear market environment and as such, should continue to enjoy the benefit from the rising tide of the past couple of years. The year ahead will undoubtedly be rocky at times, particularly as we draw closer to the bottoming of the 4-year/8-year cycle in the third quarter. But there will also be some very worthwhile rallies, including one in the early part of the year, in part due to the latent fear that has permeated the marketplace since 2003. This latent "fear factor" can always be counted on by the insiders as they use it to bolster and support the market during the weak phases and key off in buying "low" in order to sell "high." The real trouble will occur not when the news headlines are the most gloomy. Rather, it's when the sunny and carefree days of optimistic headlines start appearing with regularity -- just like in the late '90s -- that you'll know the next top is at hand.


 

Clif Droke

Author: Clif Droke

Clif Droke
ClifDroke.com

Clif Droke is a recognized authority on moving averages and internal momentum. He is the editor of the Momentum Strategies Report newsletter, published since 1997. He has also authored numerous books covering the fields of economics and financial market analysis. His latest book is Mastering Moving Averages. For more information visit www.clifdroke.com

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