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Investment Strategy

Embrace the Fear (for Now)

By Elliott H. Gue, on Sep. 15, 2015

Human nature and the stock market’s basic drivers haven’t changed appreciably since the 1960s—or even further back.

Despite all the headlines about how high-frequency trading and aggressively leveraged hedge funds have changed the way the stock market works, the parallels between the May 28, 1962, collapse and the flash crashes in May 2010 and August 2015 are uncanny.

The Dow Jones Industrials plummeting 1,000 points in the half hour after the New York Stock Exchange opened on Aug. 24, 2015, is a classic example of a market in panic mode.

And as we explain in Stop the Madness: The Dark Side of Stop-Loss Orders, the most recent flash crash underscores the danger of using stop-loss orders to control risk.

Just as investors in 1962 were perplexed when their sell orders were ultimately executed at prices well below those that appeared on the tape, those with stop-loss orders likely exited their positions at much lower prices.

Market history has demonstrated that investors who buy high-quality names in a panicked market will usually come out on top. You don’t want to sell during a wave of forced or automatic liquidations.

A market crashes such as the ones that occurred in May 1962, May 2010 and August 2015 don’t necessarily mark a bottom for the market. Although the S&P 500 could retest its August lows in coming weeks, history suggests that Aug. 24 will prove to be an excellent entry point for investors seeking to play a potential rally in the broader market to new 52-week highs in late 2015 or early 2016.

The current market bears an eerie resemblance to summer 2007, when the S&P 500 tumbled 12 percent from its intraday high in July to its intraday low in mid-August. This downdraft reflected growing concern about bad mortgage loans at major US financial institutions and toxic mortgage-backed securities—the same credit problems that were at the heart of the 2008-09 financial crisis.

But the selloff in summer 2007, which included a panic-fueled crash on Aug. 13, ended with the S&P 500 rallying to a record high on Oct. 8, 2007.

The coming bear market probably won’t be as harsh as the 2008-09 cycle; however, the narrowing market leadership we’ve highlighted since mid-2014 suggests that the S&P 500 could suffer a meaningful correction in 2016.

And although the economic indicators we track don’t suggest a US recession is imminent, we have seen early signs of deterioration that bear monitoring.

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