Extreme fear will actually keep the U.S. stock market grinding higher

Extreme fear will actually keep the U.S. stock market grinding higher

There’s a consistent pattern that occurs in stock market sentiment.

When the market starts to pull back, many sentiment measures move to bearish extremes. This is important because the market tends to fool the majority, and when everyone gets scared, it is usually a good time to buy. I have been writing about it for the past three years, and I am discussing it now because it just happened again recently.

During the second half of June, the U.S. market, as represented by the S&P 500 Index SPX, +0.65% started to decline, and many momentum leaders suffered from profit taking. In my view, this was a normal pullback to the 50-day moving average for all the major indexes.

What amazes me is the incredible escalation in fear recorded by several sentiment measures. For example, $20 billion flowed out of equity mutual funds at the end of June, one of the biggest outflows of the year so far. The CBOE total put/call ratio spiked to 1.32, an unusually high reading, as people rushed for “put” protection. The CNN Fear/Greed ratio dropped to an “extreme fear” level. The AAII Sentiment Survey saw one of its biggest weekly jumps in bearish sentiment. NAAIM (a survey of active investment managers) dropped below its recent average of investment levels.

What’s more fascinating to me is why this happens?

I have two theories:

1. The majority of market participants feel this current stock market rally is about to end any day now. I constantly hear that the market and the economy are in “late stages,” so this consistent rush for the exit makes sense if most people feel this way.

2. The financial crisis of 2008-2009 is still fresh in people’s minds, and no one wants it to happen to them again. I recently spoke to someone whose grandparents lived through the Great Depression of the 1930s, and they spent the rest of their lives in fear, worried that it would happen to them again.

I’ll be posting my 2018 second-half outlook soon. I feel that we are just starting year three of a possible five-year bull market.

Part of the reason behind my theory is that this constant fear and “one foot out the door” mentality will keep stock markets grinding higher. Think about what has happened so far in July. There are non-stop headlines about trade wars and tariffs, but the market has ignored them and marched higher.

Why? Because the market trades on psychology more than people realize. I will continue to follow shifts in sentiment because if there is one thing that has been consistent for the past 100 years and will continue to exist for the next 100 years is that the human emotions of fear and greed will never change.

Joe Fahmy is the managing director of Zor Capital LLC, a New York-based investment-management firm. He received a bachelor’s degree in economics and religion from Tufts University. Joe can be reached at jfahmy@zorcapital.com and on Twitter.

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