Stocktake: Profiting from the market panics

Profiting from the market panics Market panics are unnerving, but they're also times of great opportunity.

On Monday last week, Apple – which had traded at $112 the previous Friday – fell to $92 within minutes of trading, only to rebound to $109 within hours.

Netflix sank to $85 before almost immediately rebounding back to the $110 level it had traded at the previous Friday. Countless other stocks swung about in similarly manic fashion.

Can such swings be justified? Or should investors heed Warren Buffett, who earlier this year described "Mr Market" as a "drunken psycho" prone to irrational mood swings?

Well, Netflix is no stranger to wild price moves; it’s an expensive glamour stock favoured by momentum traders, so its rollercoaster ride is unsurprising.

Apple, however, is the biggest company in the world; not even diehard efficient market theorists can pretend it makes sense to lose $100bn in market value and then regain it within a couple of hours.

Valuation expert Prof Aswath Damodaran and Reformed Broker blogger Josh Brown give the same advice for such environments – think of daft prices for stocks you're interested in, and put in limit orders to buy at this discounted price.

Of course, your orders may not be executed. After all, your chosen prices seem absurd. "But that's the whole point", says Brown. "Market panics give you a crack at absurd prices." Big gains and big losses Last Monday's carnage was followed by the S&P 500's biggest two-day surge since 2009. Might the worst be over?

Well, we saw similar action in August 2011; over one four-day period, stocks fell 6.7 per cent, rose 5.2 per cent, lost 4.8 per cent and gained 4.6 per cent. That was two months before the 19 per cent correction ended.

Volatility, notes money manager and blogger Ben Carlson, "was a precursor of what was to come, not an end to the sell-off".

That is the usual pattern. The Dow Jones' 20 largest one-day gains occurred in 1929, 1931, 1932, 1933, 1939, 1987 (after Black Monday), 2008, and 2009 – all times of market crisis. Since 1970, notes Michael Batnick of Ritholtz Asset Management, 22 of the 25 best one-day gains occurred when stocks were in downtrends.

Corrections breed big rallies as well as big declines, so decent gains shouldn’t be viewed as proof the storm has passed. For now, investors will just have to live with the uncertainty.

Time to crack our heads open? There's a famous Simpsons sketch where TV presenter Kent Brockman asks his expert guest, "Professor, without knowing precisely what the danger is, would you say it's time for our viewers to crack each other's heads open and feast on the goo inside?"

His answer: “Yes I would, Kent.”

This approach resembles media coverage of the recent market troubles, with headlines such as “Bearmageddon is coming”, “Dow 5,000? Yes, it could happen” and “This stock sell-off has cost Americans $1.8 trillion”.

Headline writers are not the only ones at fault. When the Dow fell by more than 1,000 points last Monday morning, journalists gasped that this exceeded the biggest one-day drop on record, the 777-point decline registered in September 2008.

In percentage terms, however, a 1,000-point drop would not even have ranked among the Dow’s top 20 biggest one-day losses.

Coverage of the rallies is similarly excessive.

The Dow’s 619-point gain last Wednesday, said CNN, was the third-biggest one-day gain in history.

In terms of points gained, that’s true; percentage-wise, it ranks 131st.

It’s been volatile, but this is not 1929 or 2008. Let’s not crack our heads open just yet.

Europe's full-house buy signal Some good news: European equities are flashing a "full-house buy signal", says Morgan Stanley, for only the sixth time in the last 20 years.

Full-house signals, which are based on various fundamental and technical metrics, are associated with investor capitulation, tending to trigger in times of market stress.

Some bad news: this full-house signal can be dangerously early. Stocks fell another 18 per cent in 1998, bottoming six weeks after the full house signals.

In 2002, stocks fell for another six months, declining 22 per cent; it triggered again in October 2008, only for stocks to decline 25 per cent over the next five months.

As hands go, this one seems more like a pair of aces than a full house.