If the Dow drops just 9% from last Friday’s close, it will be a bull market reality check. Here’s why.
Let’s get right to the point: the stock market has created a lot of fake enthusiasm since early 2018. I say that because at that point, the long bull market that started in 2009 stalled.
At the time, my own proprietary indicator of long-term market conditions, known as the Investment Climate Indicator (ICI), downshifted to its lowest of four possible readings. It went to “Stormy” from “Overcast.” That was on January 26, 2018.
Stormy: explained
That was not a market call, so much as it was a recognition that any gains going forward would be associated with above-average risk. Indeed, the Dow and S&P 500 fell in early 2018, and then plunged 15% in just 3 weeks that December.
However, the Christmas Eve rally in 2018 launched the major averages to new highs. This is pretty normal for Stormy market conditions. Stormy does not mean that additional gains won’t occur. It just means that you take more risk to get them. More specifically, you take more risk to make gains in the stock market now than at any other time in the bull market (the past 10 years).
FOMO NOGO?
In particular, this is the phase of the bull market that breeds FOMO - the fear of missing out on gains. However, as it turns out, the Dow is less than 10% above where it was more than 2 years ago. In the case of the S&P 500, its about 17%.
YCHARTS.COM
Now, the Dow is off less than 2% from its all-time high. So, what’s there to panic about? Not much, if you prioritize managing risk. Unfortunately, too many investors and financial advisors don’t.
A key number for the Dow
That might change if the Dow hits a level of 26,616, about 6% below where it closed last Friday. But that’s not what I am focusing on.
That level is where it closed in late January, 2018. Returning to that level would create some interesting headlines, especially if it takes a little while to get there.
For instance, if the Dow treaded water through the election and the U.S. Presidential inauguration next January, that would lead us to the 3-year mark since the “Stormy” era began. All of those index funds would thus be showing some pretty flat 3-year track records. THAT will get headlines. And, just as FOMO can push prices higher than global market conditions would imply, that excess energy can work in the other direction, too. I am looking for signs of that as 2020 rolls on.
In order to balance reward and risk, you need to think differently. You need to adopt what I call an “Aggressive Capital Preservation” mantra. First, reduce major loss potential. Then, make as much as you can. To me, that means making much greater use of tactical positions and put and call options.
The recent 600-point drop in the Dow on Friday, January 31, re-awakened that potential for major loss. And while we never know what will happen next, it is clear that risk is on the rise. It’s Stormy out there.
This article originally appeared on Forbes.
