I'm not so sure investors are prepared for an actual market pullback.
It was nearing the end of January and the Dow had just broken above 26,000 for the first time ever. But the stock market turned lower after hitting new all-time highs and finished the day in the red.
As far as reversals go, it was a tame one. Stocks even opened higher the very next day. But we could sense some mild panic beginning to percolate. The averages had been so cooperative that even a tiny drop was making investors nervous.
That's when I started wondering how folks would react to an actual correction. Was anyone ready? Judging by the reaction to the big drop, the answer is obvious.
Up until last week, one of the big gripes about the markets was the lack of dips for investors to buy. After all, how is a trader supposed to "BTFD" when there are no dips to be found? Stocks marched higher without a care in the world. Anyone patiently waiting for a real pullback was stuck on the sidelines.
But now that we're witnessing what could be the beginnings of a meaningful pullback, we see many investors are cowering in the corner. The market has trained them to only think about potential gains and completely ignore risk.
Everyone was caught up in the excitement of the rally. We were bombarded by bullish stories every second of the day. Market action was hypnotizing. That's why it's so important to mentally prep for a market pullback before stocks start to fall off a cliff. Many investors talk a big game. But when the market begins to move against them, they're paralyzed with fear. They hold onto positions they should have sold and are left with bigger than expected losses.
It's not surprising that Monday's 4% plunge felt like the end of the world. I don't have to remind you of the historically low volatility we enjoyed in 2017. These pleasant market conditions warped our brains to the point where we didn't have to hope stocks would shoot higher on any given day - we expected it!
Judging by the action we've witnessed in the markets over the past week, the smooth ride is over.
Welcome to the new normal: A stock market that goes down every once in a while.
"It may not feel like the end of an era because markets have been so calm in recent years, but these types of selloffs should be expected in the stock market from time to time," Ben Carlson writes over at Bloomberg. "The S&P 500 is now down a little less than 10 percent from its all-time closing high on Jan. 26. This certainly could lead to a bear market in stocks, but investors have to remember that every time stocks fall it doesn't mean the world is coming to an end. There have been market corrections in both secular bull and bear markets alike historically."
These big market moves are bound to happen more often than you think:
Source: Bloomberg
The numbers don't lie. As you can see, these 2% losses happen an average of five times a year. And up until last week, The S&P 500 hadn't posted a 3% decline since November 2016. We probably won't see another streak like that for a long, long time.
For now, we need to concentrate on adapting to new market conditions. Futures are stuck in the red this morning after yesterday's big rebound. We'll need to watch how the market digests this bounce and plan accordingly.
Sincerely,
Greg Guenthner
for The Daily Reckoning