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Investor Fear Builds: Is It Enough to Entice Bold Buyers?

Michael Santoli

With so many potential market-shaking events to worry about over the next month, it’s at least heartening to see that so many people are pretty worried.

Taking comfort in the spread of anxiety among the investing crowd is in recognition of the contrary logic of markets. When fear increases – especially when it rises out of proportion to the damage already done to stocks – it usually means many nervous investors have already sold, or deferred plans to buy.

And when extremes of worry are reached, the odds of success rise for those willing to go against the prevailing sentiment and do some buying. Currently, anxiety is clearly on the rise but not yet at the kinds of extremes which might make buying this dip a “fat pitch.”

Note that not every pullback throws a fat pitch by generating clear sentiment extremes before running its course. In any case, tactical traders are beginning to look toward the June market lows, about 7% down from here, as a potentially attractive buying zone should the recent weakness snowball. (And if we find ourselves there, it won't necessarily feel like an obvious buy: You can bet the prevailing fear would be that a bruising bear market may have begun.)

A bit more downside

With the amount of pent-up selling now pressuring the market and the technical damage done to date to leading stocks, it might take a few more percentage points of downside toward the June lows to generate the degree of panic that often precedes a strong and surer bounce, barring any nasty economic surprises.

Of course, there are now plenty of good excuses for investors to be concerned. The U.S. is mulling military action against Syria, which could provoke a volatile set of adversaries and "friends of convenience," from Iran to Russia and China. History says the lead-up to limited wars is usually worse for stocks than the reality of them, but who can be sure?

Congress, meantime, returns in little more than a week with a tight deadline to fund the government and lift the nation’s debt ceiling. The months-long wariness about whether, when and how much the Federal Reserve might step back from its bond-buying stimulus actions is coming to a head, with a bare majority of economists looking for it to begin in September. And, just for good measure, the president is due to nominate a replacement for Ben Bernanke as Fed chairman at any moment.

With corporate earnings growth having stalled, housing data a bit less springy, Treasury yields having risen rapidly toward 3% before backing off in recent days, and stocks not broadly appearing cheap, it’s understandable that investors might have butterflies in their stomachs.

And, indeed, with the Standard & Poor’s 500 index down 4.6% from its Aug. 2 all-time high to Tuesday’s close following a steep one-day selloff, signs are beginning to emerge that a helpful welling-up of fear is well under way.

A lower bull tally

A long-running weekly survey of investment advisors by Investors Intelligence shows only 38% claiming to be bullish, the lowest bull tally since last November, which is when the market embarked on a strong rally. Bears are up to almost 24%, for the narrowest spread between bulls and bears since late 2012. The group anticipating a market correction – which, of course, could be what the market is undergoing now – is also at 38%, the highest since late June, near the time a rebound began.

Even before this week, professional investors were flocking toward futures contracts betting on increases in the CBOE S&P 500 Volatility Index, a gauge of how expensive it is to protect against market downturns. The VIX tends to rise when the market skids, and the number of VIX futures contracts outstanding in the first half of August was up 48% since late June, the biggest two-month jump in 18 months, according to Sandler O'Neill analyst Richard Repetto.

This has been a pattern most of the year: The muscle memory from the financial crisis and the aftershocks of the euro zone debt panic and U.S. debt-ceiling debacle of 2011 cause investors to extrapolate pullbacks into the chance for a washout, and they reach for protection or hustle to the exits.

The fact that so many of the queasy-making events are right in the headlines and come with known deadlines might mean that stocks will continue swinging with every quantum of news, the way they did while Washington mud-wrestled over the “fiscal cliff” tax deadline late last year. Anxiety is a prerequisite for a buyable dip, but not a guarantee of one.

Put together with seasonally weak market tendencies through September and the ongoing flight of risk capital from emerging markets, it’s hard to gain much confidence that stocks will shake off their malaise anytime soon.

Then again, isn’t the increasingly worried crowd quite well aware of this already?