Why do people invest in the stock market when it is forecast that a drop should occur?

Question

When reading different financial media, it is often mentioned that the stock market's drop in the spring of 2020 was not the actual bottom. Some believe that there will be a recovery close to the level before the crisis began. If looking at several indexes, this appears to be true. Therefore, a second drop may be pending.

Some people are saying that it will happen on date X. People who believe this will get out of the market, causing a drop. When others see that prices are falling, they too will leave the market, causing an even larger drop. Would this second drop then be a self-fulfilling prophecy?

So why are people investing even though there are such warnings?

Answer 1

The answer is that some people do not believe a further drop is coming, or that it will not be so large, or that it will not be so soon. The typical advice given to an individual investor is that 'time in the market beats timing the market'. This means that losing incremental daily gains on the ongoing growth of the economy has historically beaten out the periodic recessions etc. that have impacted the stock market. This can be trivially shown by seeing that the Dow Jones today is above where it was a couple of years ago.

So if you anticipated a drop in the market in 2016 and waited to invest until it happened, you would have lost all the gains from 2016-2019, and that would have more than made up for the drop thus far in 2020 [which of course is no guarantee that it will not drop further]. Trying to time the market and get in at the 'perfect moment' can be a fool's errand. The lower risk option is to invest as early as you have the funds [keeping an emergency fund in cash and barring other short term needs, of course], and not turn long term investing into something more like 'gambling'.

In this way, being 'right' about a drop in the market, but being 'wrong' in the timing and anticipating it 3, 6, or 12 months early, is the same as being 'wrong'. As the saying goes, the market can stay irrational longer than you can stay solvent.

Answer 2

Because of the simple rule: it's impossible for everyone to believe a stock can only go up or only go down.

Imagine ABC Megacorp has been doing pretty well. It's selling at $100 per share right now - but "everyone knows the stock's only going to go up."

Then how is it trading at $100? For every person buying the stock, there has to be a person selling the stock. Which means for every share that someone picks up at $100, someone has to be thinking, 'Now is a good time to get out of this stock, because it's not worth $100.' If everyone truly thought $100 was a value that could only go up... the value wouldn't be $100. It'd be $150. Or $200. Or some value where half the transactions were "Okay, that amount is overvalued - I should sell my shares."

It's the same with the market as an aggregate. If 'everyone knows' a second dip is coming soon? Then the dip would already be here, since a lot more people would be trying to sell than trying to buy.

And while there is some bandwagon'ing when stocks dip and people panic-sell, the phenomenon I'm describing above is actually what corrects it. If the market plunges again? Then a lot of people say, "Hey, I think these stocks are undervalued - time to invest a lot of money while it's cheap!"

Answer 3

Every day, people assimilate the news and come to conclusions about the health of stocks or the market. Based on those opinions, they transact. When trades execute, for every buyer, there's a seller. Let's make a simplistic (albeit incorrect) assumption that every buyer is bullish and every seller is bearish. That means that one side of every trade is wrong, regardless of what the current price of the stock or the market is.

Many are always going to have an opinion whether they be retail traders, investors, market pundits or research analysts. Some number are going to be wrong, even dramatically. Two months ago when the market dropped 35%, many were predicting that we were in the early stage of a depression worse than 1929. Others predicted that we were going to have a sharp V shaped recovery.

The key phrase in your question was "... a second drop may be coming." That's true it may be coming. Or perhaps, maybe not. That's what makes a horse race. Some win, some lose. If you firmly believe that another 35% (or more) drop is coming soon and you exit some/all of your positions, you will be rewarded nicely for your prescience if that drop comes to pass. If not, it may cost you (taxation if non sheltered) and possibly an opportunity cost if the market rises instead.

It doesn't have to be black and white, in the market or out. You can reduce risk in a variety of ways but that's another discussion.

Answer 4

Many people believe that for any selection of stocks it is impossible to "beat" the market, that is, to expect to invest more successfully than mechanically following an index covering the whole market; i.e. the Efficient-market hypothesis.

This automatically implies that it is, for all means and purposes, impossible to predict the market in any way. It does not matter how obvious a forecast is, or how prolific the oracle is. It has been shown time and again that forecasts are not reliable. And if they are, then it is already too late - that is, if you and me as regular investors are absolutely sure that the market will crash, then the crash has already occured. The current stock exchanges are incredibly fast, there is no way at all that a normal customer can react fast enough to make any change.

(Note that all of this excludes insider knowledge, obviously - for example, say you know of a certain decision about a company being made public in a week, this gives you a worthwhile heads-up. Or if the heads of a state learn of an upcoming pandemic from reliable sources, and trade their stocks based on this information before informing the public, then they are, indeed, able to "beat" the market. Therefore, insider trading is generally illegal, and is not what this answer is about).

There have been many occasions in the past where, for example, the market seemed "overheated" and people were predicting a crash coming soon. This same situation would then go on for years, while the market did not care and increased continuously. If you had invested, you would have made a nice profit. By not investing you lost it. The opposite is of course true as well.

A valid investment strategy thus is to invest always, no matter what the market does, and in a cheap index instrument which follows the whole market. No forecasts whatsoever are needed. This is a long-term strategy, obviously; crashes will happen, and you will simply sit them out. If you want to know more about the theory behind this thinking, check out The Intelligent Asset Allocator, a nice allround look into these topics.

A nice psychological side effect is that if and when a crash happens, you can be pretty happy about it - maybe you have some cash in the bank and can quickly push it into your index of choice; the assumption is that long-term the index will rise. You can decide for yourself if this is a fallacy or not (after all, you never know when the bottom of the crash has happened), but it is healthy for your psychological state. This may sound funny, but it is in fact incredibly important. After all, a scared investor dumping all his stocks during a crash is 100% sure to lose. Being able to sit out these kinds of down-and-up movements is a very strong instrument in itself.

Answer 5

Historically, there has almost always been a second drop after a recovery, sometimes more. This is why many people believe another is coming. However, there was a market correction in December 2018. Many feel this was the first drop, and March 2020 was the second, even though they were unrelated. There are also many variables that are different from previous bear markets that give investors incentive to continue investing and not wait it out.

• The federal government acted quickly with historic bailouts, and investors are expecting a second wave of bailouts within the next month.
• The government was ultimately responsible for the downturn by its response to covid19, not corporate financial struggles, which could end just as quickly as it started. Currently things are starting to open and so far the covid transmission rate has yet to increase.
• Interest rates have been at historic lows since the last bear market. If I put my money in savings, the interest rate is less than inflation, so it loses value, assuming inflation is between 2%-3%. I may put it there temporarily during the drop, but I'm not going to keep it there long because its a negative investment. Even the 30 Year treasury bond is low at 1.6% as of today.
• The first drop was also hit by an oil spat between Russia and Saudi Arabia sending oil to record lows (oil futures went negative briefly) which has since been resolved. The oil supply is still quite high, but assuming the government continues to allow companies to reopen, demand will increase. This factor would be eliminated if there was a second drop, one could surmise that a second drop would be smaller.

Answer 6

Because, and it's impossible to overstate this, the current price of the stock market contains all the public information from the entire world about what price it should be.

If information dictated that the stock market was going to be 2% lower tomorrow, everyone would sell until it was at around that price.

The stock market is almost impossible to predict, nearly all people who can predict, even parts of it, are doing so because they have inside, secret information that others don't have.

What is much easier to predict, is advertising revenue on articles, so, if you are good at writing it's certainly more profitable to write articles about you dumb opinion on the market and make money from people reading them.

To think about it another way, if someone actually knew what the market was going to do, telling others about it would just reduce their capacity to capitalize on that information, so if someone is sharing information for free about a 'hot new stock' or an 'incoming immediate dip', it's not good data.

Some fun examples that got made into movies. The Big Short, in that movie the people making money off of the drop only told a few people so they could make millions themselves. In Wolf of Wall Street the protagonists make money off of sales, because they recognized that making money off stock is near impossible.

Answer 7

Because stock ownership with an oncoming downturn is a game of "hot potato".

The stock market does not level out and then coast down the other side. Instead it ramps up near-continuously and then falls off a precipice. If you keep trading right up to the downturn, you will still get returns on your investment.

The last person left holding the stock loses out, of course. But everyone is just gambling that they are not the one left at the end.

Because downturns do recover.

And all that said, the person left at the end only loses out in the short term. In the long term, the market will recover eventually. So long as the company survives, the stocks will regain their value. Of course the return over that time will be lower than you could have got by putting the money into a bank account, but if you can wait out the recession then you won't completely lose out.

Answer 8

Because there may be opportunities in the drop. Take the current pandemic. People have been staying home, which means stocks like Disney that rely on people going somewhere are tanking, while stocks like Amazon that don't need people to go anywhere are doing really well. That's a simplistic (and not entirely accurate) example, but there are usually two sides to every big market change. Smart investment is not really about avoiding the market in downturns. It's about identifying who the winners and losers will be.

Answer 9

The stock market's fall may have you on edge. But if your long-term goals didn't change today, your investments probably shouldn't either. Most People Should Sit Still. Economists had forecast the unemployment rate to increase to as much as 20 percent, after it hit 14.7 percent.

Answer 10

Because of day traders chasing short term gains

First of all I agree with your premise that the stock markets are more bullish than common sense would dictate at the moment. Obviously there isn't necessarily a direct correlation between the health of the economy and the stock markets, but considering the likeliness of near future redundancies and small business closures (just think of all the local restaurants, hotels, cinemas and the myriad of other small businesses that rely on footfall) then in my mind there's likely to be a slow down in consumer spending coming, and down the line will have a short/medium term impact on big businesses revenue.

One possible explanation is there is a massive increase in day traders at the moment, which seems to be due to a combination of people having a lot more time at home and a reduction of sport events to bet on. Not only that but a lot of these day traders are doing extremely well for themselves betting long at the moment (everybody is a genius in a bull market). This could be to some extent similar to what you describe in your OP i.e. people are buying because the market is in an uptrend so its a self fulfilling prophecy. And if that's the case then as you suggested as soon as momentum turns then people might start selling just because that's what others have started doing and then cause a strong down trend. Bear in mind even if you think the market is going down soon it doesn't mean all these day traders are making bad choices and as long as they are making money now and aren't the ones holding the shares when a down turn happens without reacting quickly enough then they may still may end up doing very well.

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Answer 11

My answer in four words: “Don’t fight the Fed”