How Fear Could Halt a Market Correction

On the back of yesterday's losses, U.S. stocks opened slightly higher this morning as the number of Americans filing new claims for unemployment benefits last week fell by 11,000 to a seasonally adjusted 346,000 (to be clear, the causal link here is not established, as the figure is in line with the average forecast in a Reuters poll of economists). The S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) are up 0.14% and 0.11%, respectively, at 10:10 a.m. EDT.

The two faces of fear
In investing, there are two kinds of fear: fear of loss and fear of lost opportunity, which naturally induce opposite actions. Fear of loss motivates investors to withdraw from the market and remain on the sidelines. That has been a dominant factor in the behavior of individual investors, which is why I awarded the current bull market the title of "The Most Mistrusted Stock Market Rally in History." Or, as UBS CEO Sergio Ermotti, who oversees one of the world's largest private wealth managers, told CNBC yesterday afternoon:  

Clients' risk appetite remains ... almost paralyzed, (with) very high level of cash balances. And this has been the case for the last seven quarters. ... We are really at levels of risk aversion ever seen in the industry.

With the stock market taking a break from its lockstep upward advance since mid-May, that fear may now seem justified. However, the second type of fear is also at work in a market that has experienced a massive rally since the bear-market bottom on March 9, 2009 (see graph below). As Ermotti explains, "It's the higher it [equity market] goes, the more nervous people get and frustrated at not being in the market." That's particularly true when the rally seems to be going from strength to strength, establishing repeated (nominal) record highs, as it has done this year.

^SPXTR data by YCharts.

Having witnessed this rally, investors who have been on the sidelines may feel that a modest decline is healthy -- and they may see the opportunity to finally get into the market in order not to miss out on future gains. And why not, when they are constantly hammered with the notion that stock valuations remain reasonable, with the S&P 500 valued at less than 15 times estimated earnings for 2013 (on a cyclically adjusted basis, things look a little different).

I don't know how things will shake out (nor does anybody else, no matter how confident they sound), but fear is at least one thing that could prevent the recent swoon in the market from turning into a rout.

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