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Why the Market Finally Corrected

Richard Peterson wrote in a newsletter to his private clients on July 12: “The rally is rolling over in U.S. stocks.  Fear is creeping in, and we’re likely to see a period of volatility and a real correction in the late summer/fall. Time to pull back and be more cautious.”

Talk about dead on.

Peterson is managing director of MarketPsych, a behavioral finance consultancy, and his prediction was based on his company’s measurements of positive and negative sentiments in the markets. Based on positive sentiment, he’d been bullish on the market for about a year, but then he started seeing serious fear building up around certain segments.

Such fears have been a long time coming. As I noted in a column in June of last year, Federal Reserve officials were starting to worry that an ominous tranquility had settled over the markets after years of gains. Such a stretch of calm prosperity could lead to bubbles, they felt, as investors grow unafraid of risk and take too much of it on.

I quoted Bruce McCain, chief investment strategist at Cleveland’s Key Private Bank, who called it a “bubble in complacency.”

So why did the bubble burst now?  There has been plenty of bad news for months, given Greece’s and Russia’s problems, and China’s inflated stock market and slowing economy.

Peterson, who is also a psychiatrist, uses an analogy that is particularly apropos these days, given the record wildfires consuming so many acres out west. He says the lack of corrections turns the market into “a forest that hasn’t burned in a long time.” The potential for trouble, like underbrush, grows with each month of complacency.

Problem spots in the world, such as China and Russia, are like “sparks that start the underbrush smoking.” Fear can act like a contagion, Peterson says, and it can quickly spread through world markets, fanning the sparks until they burst into flame and markets burn.

Fear spread China’s stock market to markets in the U.S., Australia, Japan, South Korea … and so on.

Yes, we were overdue for a correction, but the panic and wild market gyrations are emotional responses. Investors are wise to understand that emotionally-charged swings and the commentators who try to find meaning in them are, as Macbeth said about life, “a tale told by an idiot, full of sound and fury, signifying nothing.”

Another analogy comes from Peterson’s partner at MarketPsych, Frank Murtha, a psychologist. He calls the sudden fall of the markets “classic Wyle E. Coyote Syndrome.”

Says Murtha: “Wyle E. can run off the cliff and he won’t fall.  He’ll just keep churning his legs and defying the laws of physics, until he finally looks down. 

Markets do the same thing.  They run off a cliff and defy the laws of economics and finance until enough people start to look down.”

Murtha adds that many pundits are saying they’re not surprised by the market moves, just how fast they occurred. But that’s dated thinking, he says. “This is the new normal, things happen in an instant now. A bomb goes off in Bangkok and the markets in New York are rattled instantly.”

Given that the markets are profoundly influenced by mass psychology, how can you deal with the swings, individually?

Murtha advises that if people need some peace of mind when the markets go nuts they should “nibble.” In other words do a little trading, not for financial reasons, but for emotional reasons. “Simply taking some action, even a small one, increases one’s sense of control, which can be in short supply at a time like this.”

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