CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Please ensure you fully understand the risks involved. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Please ensure you fully understand the risks involved.

This market does not want to rally

It seems that despite low valuations, washout breadth readings and dramatic falls, the ‘buy the dip’ crowd have not showed up yet.

Index data board
Source: Bloomberg

It has been an interesting few weeks for investors. We have seen one of the biggest sell-offs in recent memory, and overall stocks have lost around $8 trillion in market capitalisation, the largest amount in ten years. Not since the global financial crisis have we seen such losses.

It must be said, of course, that global stocks have risen significantly in the past decade, going from around $30 trillion in total market capitalisation at the beginning of 2009, to $80 trillion by the beginning of 2018.

Currently, the loss is a blip, but not much more than that. All corrections feel dramatic in real time, and this could well be the start of something bigger. However, the ‘average’ drawdown in any given year for the S&P 500 is 10% so the current sell-off is still within the expected bounds for such events.

Even if this is the beginning of another significant bear market, we should expect dramatic rallies akin to the bounce seen when a ball is held underwater. It is impossible to know in advance how far the rally will go. If it can take out the previous highs in the S&P 500 and/or the Nasdaq, for example, then ‘normal service’ may be resumed.

But if it creates a lower high, the odds of another sharp drop increase. February 2018 is our textbook example of this latter possibility. The market slumped from a record high, then surged, but fell back once more. Only time will tell.

Given that the US is still (probably) some time away from the start of the next recession, the most sensible view to take at present is still that there will be new record highs for US indices in due course. A week ago it would probably have been safe to argue that this would happen before the end of the year, but now it looks less certain.

Previous dramatic sell-offs have compelling upside risk-reward over the short, medium and long terms. But there will be plenty of volatility along the way. The way to approach this kind of market is to use smaller position sizes and wider stops. Successful trades can be added to, and losers ruthlessly dropped (or allowed to hit their stop). The most important skill here is learning to run winners and cut losers, adding longevity to your trading account.

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