Markets: Be Ready for Oedipus Negative in January

This article was written with Oliver Pursche, the Co-Portfolio Manager of GMG Defense Beta Fund. It was part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

NEW YORK (TheStreet) — I like to consider myself an armchair psychologist. In the chicken/egg taxonomy of this phenomenon, the years of trying to understand the markets made me this way, not the other way around.

As you may know, there is an entire school of thought devoted to the irregularities and inefficiencies in the market known as behavioral finance. It’s within this framework that I offer up the two charts below suggesting a striking degree of similarity between them.

The top one is Rubin’s vase, named after the famous Danish psychologist Edgar Rubin. Looked at one way, it’s a vase, looked at another, it’s two faces. In the vernacular, this is known as an ambiguous or bi-stable form.

The chart below Rubin’s vase, developed by my firm, shows the emotional well-being of investors correlated to market returns. The brown bars represent the S&P’s annual return, the blue dots represent investors’ emotional well-being, and the little red dots show the low point of the market in any given year. Note every year the market went into the red at some point. Also note that 25 of 32 years the market return was positive.

OK, now how is it that Rubin’s vase and the chart immediately below are very similar, if not exactly alike?

Give up? OK, here’s how. At first glance, the chart illustrates the very simple point that when markets are up, we feel good about them and our investments. But keep looking and another very important idea will begin to emerge: The greatest opportunities for gains come at the points where we feel negative about the markets.

Specifically, if you could get your courage up about the time you felt worst about the markets in 2008, investing in stocks offers some 60 points of upside. It you felt pretty bad about the state of affairs after the dotcom crash in 2000, that was the time to get back in. If you were a real soothsayer, you felt your worst in 2002, when markets were off by some 25%, to be rewarded the following year, when markets returned about 26% for a spread of nearly 50 points. Even if you hit your emotional bottom a little early, say in 2001, you did pretty well in the rebound two years later.

I’m not advocating market timing, which is correctly dubbed one of the world’s most difficult feats. I am suggesting that if you are invested in the market, and keep some powder on the side, history shows the time to use it is when things look their worst.

For better or worse, one such opportunity may arrive later this month. Specifically, the current anxiety — that fiscal cliff legislation was not enough, that a debt ceiling battle is brewing, that Europe will implode, that Europe will not implode, take your pick — coupled with difficult comparisons during the upcoming earnings season may conspire to deliver what I estimate to be a six to eight point decline in the S&P 500 index during January.

Should this materialize, for better or for worse, it’s going to take your sense of emotional well-being right down with it. And once you’ve got that sinking feeling, you’ll know what you’re supposed to do.

For the record, and to let you know I’m not just an armchair psychologist, but a real investor and fiduciary, here are stocks and sectors I’ll be looking to double down on should the markets, and my mood go south in January.

Global recovery: Cliffs Natural Resources (CLF), CSX(CSX)

Housing recovery: Bed Bath & Beyond(BBBY), Kohl’s(KSS)

Technology upgrade: Novo Nordisk(NVO), Cognizant Tech(CTCH)

Food and beverage: PepsiCo(PEP), Molson Coors(TAP)

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