Most major financial news services deliver a steady diet of fear. Rather than become afraid, we must all learn to embrace it – not run into the cave and hide. Here’s why:
There are two things that provide the stock market with energy to rally:
1. Lower interest rates
It’s easy to understand why lower rates spark rallies. They save the economy and boost the value of dividends and future earnings. They also reduce the yield of your primary investment alternative. We explain the calculate of this variable in another essay. For now, let’s study fear.
How are we going to measure it?
To begin, we make use of the Vix index which is the price of buying insurance on the S&P 500. It must be deflated for market volatility beacuse Vix will always be higher when volatility is higher (and the converse). What does this look like?
The proxy for fear rises when the market falls, just as one would expect.
Let’s play a game.
Paratrade will buy the market when fear is up (above its 20-day average) and you’re going to buy it when fear is down (below that average). One would expect to benefit from buying dips in a bull market and get hurt when the market trends down as it did in 2008-2009. In fact, from ’07 to ’09 the buy-fear program made 200 points and the buy-calm lost 800 points! For the entire ten-year history, Paratrade made 1085 points and you lost 349 points.
You can see how we lost badly during the January meltdown but made it all back and then some, while you avoided all the pain but in the end, lost money.
Another Key Factor
If the market has a rather severe set-back, many participants panic. If we buy even more in the first 20 days after such a bout of trauma, we’ll get in before the panic-strickened finish buying back all the stock they should have never sold. What we do is allow ourselves to buy twice as much during these monthly periods. (There are 1136 such days out of a total of 2350 days in this sample.)