Well, it took long enough.
After six months of markets locked in a narrow trading range, U.S. investors finally have awoken from their apathetic slumber.
Global stock markets sold off sharply yesterday in response to the unfolding crisis in Greece.
The technology-heavy Nasdaq suffered a three-standard-deviation drop based on the last three years of price action. Put another way, you’d expect such a drop to occur on only three out of 1,000 trading days.
And according to the CNN Fear and Greed Index, U.S. investors are now officially in “extreme fear” mode.
The last time investors were this pessimistic was back in October, when the Index hit 0 for several days over the course of two weeks.
As painful as these moments are, taking advantage of these occasions can really juice your portfolio’s returns.
Mr. Market’s Moodswings
Such sell-offs are always more about market sentiment than actual fundamentals.
Sadly, market sentiment is the red-headed stepchild of stock market investing.
In a world awash with and bedazzled by complex financial models, gauging market sentiment doesn’t seem as legitimate, as, say, fundamental analysis.
After all, the best investors in the world know that the short-term price of financial assets is driven by little else.
Warren Buffett was a disciple of Ben Graham and a value investor. That places Buffett firmly in the fundamental analysis camp.
Yet, Buffett has said that the single-most-important thing he has ever read was Graham’s chapter on Mr. Market’s Moodswings in “The Intelligent Investor.”
In his book, Graham compares the market to a manic-depressive.
Some days, Mr. Market is euphoric. On other days, he’s very depressed. If you catch him on a euphoric day, he wants a very high price for his shares. If he’s in one of his down moods, he’s willing to sell you his shares for a pittance.
Mr. Market highlights the one thing you can predict with certainty about financial markets: investors will always overreact to events — whether positive or negative.
And it also highlights how savvy traders profit from just such overreactions.
Buffett himself walks the walk.
The last time the U.S. stock market experienced a 20% correction was in August of 2011.
In the first week of August, Buffett was buying his core holdings of stocks hand over fist, taking advantage of a fire sale in stock prices.
Why Market Sentiment Matters
Of course, having been indoctrinated into the Theory of Modern Finance, propeller-head analysts and professors dismiss market movements as mere deviations from an ordered, rational market where today’s price perfectly reflects tomorrow’s investment prospects.
Although an overeducated propeller-head myself, I think that is balderdash.
If nothing else, there are plenty of data-driven ways to measure market sentiment, as well.
For example, according to a study just published by sentimentrader.com, sharp drops like yesterday’s most often signal price weakness only over the shorter term. Looking at cases stretching back to the 1970s, the week or so following the “shock day” was most likely to be a buying opportunity.
With the median decline in the 3% to 5% range, it generally paid to let the initial shock settle before getting back into the market.
But after that, it was time to buy, buy, buy.
My Mother’s Strategy During the Crash of 1987
You don’t need to have a degree in finance to employ this strategy.
I remember that after the 1987 crash, my mother went out and bought U.S. stocks hand over fist.
And as a retired English professor, she wouldn’t know — or care — about the difference between a price/earnings (P/E) ratio and a balance sheet.
She simply made a big bet the world would not end and that the U.S. stock market would eventually come back.
I think if you would examine the compounded benefits of that single decision over the past 28 years, the results would be remarkable.
The bottom line?
You can analyze the current Greek debt drama to death.
Only those who are very close to the negotiations know what the real deadlines and redlines are.
But this is no “Black Swan” event.
Because the crisis has been so well-telegraphed, it’s likely that even if Greece exits the euro, the European Central Bank will ring fence Greece, lending liberally to other European banks, thereby minimizing the prospects of lasting damage from any related contagion.
Keep calm, and wait for the market to settle. Then hold your nose, and buy, buy, buy the stocks that are most oversold in your portfolio.
That is exactly what I intend to do over the next few days.
In case you missed it, I encourage you to read the e-letter column from last week about two ways George Soros could profit from Greece. I also invite you to comment in the space provided below my commentary.