Stocks were clobbered again yesterday.
The back-patting in the financial media who senselessly predicted “volatility” in 2016 is frustrating, useless, and counter-productive.
They are missing a critical underpinning of this sell-off entirely and will pay a high price for it in time.
You don’t have to pay that price though.
In fact, investors who understand a key driver of the current slide can use it to their advantage throughout the rest of the year and beyond.
Here’s what I mean.
Up Stairs And Down Ladders
The reason this correction has been so swift and severe is because stocks have been on a “hair trigger” for months now.
Your editor realizes stocks always drop faster than they they rise.
For example, earnings season is coming up. The winners will jump 2% or 3% on average after a good report. The losers will drop 10% and more after a bad report.
If you go back to the the credit crisis, you’ll see it only took 18 months to wipe away 13 years of gains in stocks.
Those are just two examples out of an endless number we could point to.
The thing is right now, this pattern is set to get far worse than it has in years.
The main reason is because of one of the biggest drivers of the current bull market has reached an historic top.
You see, one of the elements which helped push stocks to all-time highs has been investors buying stocks with borrowed money.
Greed is a powerful force. When investors are confident, they will go “all in” on stocks and many more will borrow money to buy even more stocks.
That’s great when stocks are rising. It’s downright cataclysmic when stocks start to drop like they are now though.
This chart below which compares margin debt levels (that’s what investors use to borrow money from their brokers to buy stocks and why it’s called “buying on the margin”) and the S&P 500:
The correlation is obvious.
When stocks are high, confidence is high, and investors, as a group, tend to load up and borrow hundreds of billions of dollars to buy more stocks.
This makes a good market a great one and a bad market a terrible one.
That’s what we’re seeing right now. A bad market turning terrible. And that’s a potentially great thing for investors like you.
2016: A Year Of Extremes
As you know, investors tend to react to emotions.
There aren’t too many more powerful emotions than the one created when a stock or market sheds 5% or 10% in a week.
One of the few emotions that is more powerful is the one created when a stock bought on margin drops 5% to 10% in a week.
High margin balances directly correlate to extreme drops in stocks.
There’s no more panicky, quick-to-sell investor than one who has borrowed money to buy stocks.
That’s something we’re sure is exacerbating the current downturn and will continue to do so for the foreseeable future.
As we like to say, sell hope, buy despair.
If you believe that, you should be looking forward to sell-offs like these. They will create a lot of despair.