When the Pessimism of Others Becomes Your Friend

Eran Peleg, CIO August 16, 2017

In recent weeks, a new fad has emerged amongst market strategists, hedge fund managers and media market commentators – everyone seems to be warning against a looming major market correction.

In contrast to moderate market pullbacks, that can happen anytime for the most trivial of reasons (especially in an overbought market), major market corrections are less frequent and will occur when market participants least expect them. They are sharp because market participants do not see them coming. They are not prepared for them. A new, unexpected, risk suddenly appears and is quickly priced into markets. Bang.

Investor sentiment is often negatively correlated to market risk. This is most clear at the extremes: risk to asset prices is at its maximum when investors are most optimistic, euphoric – for example, in 1999 at the top of the growth stock bubble or in 2007 when everyone was sure that real-estate is a one-way bet. On the other hand, market risk tends to be lowest when market participants are most pessimistic – think about the poor sentiment prevailing in early 2009, just before the equity market embarked on what was to become a multi-year bull cycle.

Today, we are not at an extreme. However, when the air is filled with warnings and investors are moving to reduce their risks (we are seeing evidence of increased hedging activity recently) -- when caution replaces optimism and becomes prevalent -- the probability of a major market correction scenario is reduced. This is not to say that there are no risks out there. It is just that when everyone is already aware of them, they pose less danger to markets.

What about the risk of a full-blown equity bear market developing? It is rare that a bear market -- a sustained fall in equity prices -- occurs outside of an economic recession. And economic indicators do not currently point to a developing recession. In fact, global economic activity and corporate earnings have been improving in recent months.

In investing, having a somewhat cautious mindset is generally a good thing – you are prepared for the worst. No doubt about it. This holds true especially if others are becoming increasingly optimistic.

However, when caution becomes widespread, market risk is somewhat reduced and you are better protected. So – perhaps counter-intuitively, the more warnings I hear, the more comfortable I become.