The Big Move Came. What Happens Next?

My August 30th free blog post was titled “The Next Big Move is Coming“. By almost all standards Friday’s 2.5% freefall qualifies as that move. We’ve been lulled into complacency by this summer’s tight, sideways trade, but we knew it couldn’t last forever.

Friday’s volume was the highest we’ve seen since the Brexit, but certainly not over heated considering the size of the accompanying price move. The selloff crashed through all kinds of technical levels and triggered most automatic stop-losses, but the relatively constrained volume suggests we didn’t set off a frenzy of reactive and emotional selling. That can be good or bad depending on how you look at it. It is nice to see most owners remain calm during a painfully ugly period. That bodes well for a rebound if these owners keep their composure next week since confident owners keep supply tight. But the opposite argument is Friday’s turnover didn’t look capitulatory. That could lead to further losses if emotions and fears flare up next week.

A major theme in my August 30th blog post was the risks associated with holding a sideways market. Every day we own stocks we expose ourselves to the unknown. When we buy right, the market moves in our direction and we get paid for holding that risk. But in a sideways market, we don’t get compensated for holding risk. All risk and no reward is a lousy trade. Long-term investors can sit through these flat stretches and subsequent gyrations, but shorter viewed traders should avoid owning flat markets. Quoting William O’Neil, “all stocks are bad unless they are going up”. While it is helpful to critique the past, what everyone really wants to know is what comes next.

The widely circulated explanation for Friday’s selloff was disappointment over no additional stimulus from Europe and the prospects of a near-term rate-hike by the U.S. Fed. Allegedly this “news” turned traders into sellers on Friday. The question for us is if this was a one-day tantrum, or the start of something far more significant.

The key is figuring out the real reason people were selling on Friday. Anyone who honored their stop-loss levels was flushed out automatically as the market smashed through every technical level established over the last few months. While this technically driven selling added fuel to the fire, there are not many technical levels left to violate. That means most of the autopilot selling is behind us, allowing us to focus on the trading decisions made by humans.

Humans sell for rational reasons and they sell for emotional reasons. Let us start by examining the rational hypothesis. The Fed is going to raise interest rates at some point in the near future, the only real debate is if that 0.25% hike comes in a few days, or a few months. You have to be living under a rock if you don’t know it is coming because the media has been obsessing over it for years. We survived the first rate-hike last December and even traded higher following it. Were traders really selling on Friday because they are afraid of a 0.25% rate hike? Let me ask you, are you afraid of a 0.25% rate hike? Or is something else driving people to sell?

I believe very few stock owners are personally afraid of this rate-hike. This is old news and 0.25% isn’t that meaningful. Certainly not enough to derail our improving economy. And if someone really is terrified of rate hikes, they would have cashed-in months, if not years ago when we first started debating this. People who are afraid of rate-hikes don’t own stocks in this environment plain and simple. If they don’t own stocks, they are not selling stocks. (most investors don’t short stocks)

If traders are not selling because of the rate hike, why are they selling? It comes down to Game Theory. People are not selling because they are afraid of a rate-hike personally, they are selling because they think other people are afraid of a rate-hike. The financial press has conditioned us to believe stocks are going up because of easy money and prices will fall once the spigot is turned off. Say something enough times and people believe it.

We make money in the stock market, not by predicting the future, but predicting what other traders will do. Even though we might not fear something personally, if we think the crowd will get spooked by a headline, we will sell ahead of the anticipated decline. That is what really happened Friday. Traders are not selling the economic damage of a rate-hike (real), they are selling ahead of what they think will cause a selloff (imagined).

What does it mean if most traders are only selling because they think other people will sell? It means there is no meat to this selloff. If no one is changing their personal outlook about the economy, then they will continue to have the same appetite for stocks. While they might cash in some chips ahead of the widely expected “rate-hike crash”, they will jump back in once the waves settle down.

Value investors are not afraid of a trivial bump in interest rates and will start buying the dip once prices get so attractive they cannot resist. This pullback also gives underweight money managers the opportunity to salvage their year by buying stocks at prices they wish they had bought earlier in the year. When there is no real fear in the market, traders jump back in quickly and is why this rate-hike weakness will be short-lived. No doubt emotion and fear could flare up Monday as traders sell “before things get worse”, there is very little substance behind this move and we should be looking to buy it, not sell it. There is no reason to rush in and catch a falling knife, but once prices stabilize, don’t dally and miss these bargains because they won’t last long.

Are you personally afraid of interest rate hikes? Or are you going to take advantage of these discounts? Let me know in the comments below.

Jani

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