Stocks are flashing bearish signals of more trouble ahead.
By now, you might already feel exhausted by the market’s recent whipsaw action. The Nasdaq is down more than 6% year-to-date, erasing gains it’s made since September.
The biggest market story of the past few years was, of course, Nvidia (NVDA) , which is down 15% this year, continuing a trend of weakness that began in May of last year.
It makes sense to load up on techs during a roaring bull market, as this sector thrives on the high growth potential from innovation, investor optimism and increased consumer spending. But as we’re seeing, even with Nvidia’s revenue and earnings growth, investors are selling instead of scooping up shares at bargain prices.
Now, we all know we’re supposed to “buy low and sell high,” but that just doesn’t sit right with a lot of investors. I understand; I worked at Investor’s Business Daily for 10 years, where the rule was to sell when the market is heading lower.
The rules have actually loosened up a little in the past few years, but nonetheless, the impulse to hit the sell button and head for the hills remains strong with many investors.
In reality, that’s actually a trading mentality more than investing.
Does Pessimism Lead to Market Declines?
There’s plenty going on to scare investors right now, and investor pessimism is high, according to the American Association of Individual Investors' recent survey.
According to the AAII, “Bearish sentiment, expectations that stock prices will fall over the next six months, decreased 6.0 percentage points to 52.2%. Bearish sentiment is unusually high and is above its historical average of 31.0% for the 17th time in 19 weeks.”
But this may surprise you: Bearish sentiment doesn’t reliably forecast market downturns.
In an article titled "Investor Sentiment Hits Extremely Bearish Levels," published on February 27 by LPL Financial, portfolio strategist George Smith noted:
- "Historically, when the bull-bear spread has been at comparable levels of more than two standard deviations below the average (which has occurred only 4.1% of the time going back to July 1987), S&P 500 returns have been above average.”
- "The subsequent three-month, six-month, and one-year returns have been 0.3%, 0.7%, and 0.6% above the average, respectively."
Don’t Miss Out on Expected Return
The LPL analysis of the AAII sentiment data illustrates an important point: Attempting to time the market is challenging, to say the least, as consistently predicting market movements is exceedingly difficult.
Think about it: If it were that easy, everyone would be doing this, all the time.
David Booth, Founder and Chairman of Dimensional Fund Advisors, wrote, "As access to investing expands, it becomes even more important to adopt an investment plan that doesn’t try to actively pick stocks or time the market. …Investors actively trading are not just potentially missing out on the expected return of the market—they're stressed out, worrying about how the news alert they just received will impact their long-term financial health, and whether they can or should do anything about it.”
Supporting this perspective, a study by Dimensional analyzed 720 market-timing strategies and found that only 30 delivered reliable outperformance compared to a buy-and-hold approach.
According to Hartford Funds, "Avoiding the market’s downs may mean missing out on the ups as well. Seventy-eight percent of the stock market’s best days have occurred during a bear market or during the first two months of a bull market. If you missed the market’s 10 best days over the past 30 years, your returns would have been cut in half. And missing the best 30 days would have reduced your returns by an astonishing 83%."
This suggests that the vast majority of timing strategies fail to consistently add value.
Managing Risks Through Smart Investing
Given these challenges, we’re seeing more and more advisors, fund managers and brokerages recommend a broad asset allocation strategy. Diversified solutions make it a more simple process to pursue reliable sources of higher expected returns while managing risks and costs efficiently.
Diversification remains a cornerstone of risk management. By spreading investments across various asset classes, such as stocks, bonds, and alternatives, you can mitigate the impact of any single market downturn.
This strategy, combined with dollar-cost averaging, helps smooth out returns over time, reducing overall portfolio volatility.
Diversification
By spreading assets among stocks, bonds, real estate, and other categories, investors can reduce the impact of a decline in any single asset. This strategy aims to achieve more stable returns over time, as different assets may respond uniquely to market conditions.
Dollar-Cost Averaging
This entails investing a fixed amount at regular intervals, regardless of market conditions. If you’ve ever contributed to a 401(k) and set it on autopilot, you’ve seen how this works.
This method allows investors to purchase more shares when prices are low and fewer when prices are high, potentially lowering the average cost per share over time.
Investing in a Downturn
Sure, there are steps you can take in a downturn to shore up your investments. Take the opportunity to evaluate whether your portfolio is too risky.
For example, it may be tilted too heavily toward stocks if you’re in retirement. You might also be invested too conservatively, holding too much in cash or bonds.
Investing during a downturn requires balance, not overtrading and certainly not panic.
Assess your portfolio’s risk level and adjust if necessary. Diversify across asset classes to reduce volatility and consider dollar-cost averaging for long-term growth.
Staying disciplined and patient can help you navigate challenging markets and position your portfolio for future recovery and growth.
I’ll wrap up with this chart from Fidelity, showing how dollar-cost averaging allows a long-term investor to buy more shares by continuing to invest in a down market.
According to Fidelity, “As you can see, dollar-cost averaging during the bear market can let you accumulate more shares. If you are a long-term investor and can ride out the market's temporary decline, that could set you up well for when the market eventually recovers.”
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