Just when the markets looked so promising to so many investors… reality bites. Hard.

And those hard-bitten investors are freaked out.

Here in the United States, the specter of a second wave of COVID-19 infections is looming large, particularly in states that have been “reopened” for two or three weeks now.

Not only that, but renewed lockdowns are currently underway in Beijing, China, because of a new cluster of cases linked to a seafood market there in the capital. About 90,000 people in 21 communities are shut in as the city government takes “resolute and decisive measures” in “an extraordinary period.”

As unsettling as that is, that’s not the biggest market-crashing threat out there right now.

It’s much closer to home…

At Least 2 Million New, Inexperienced Investors Are in the Arena Now

It’s not making the front pages in the financial media, but the truth is millions of new retail accounts have been opened since late winter when the coronavirus pandemic began to pick up steam. Charles Schwab alone opened 609,000 new accounts in the first quarter of 2020, and another 1.25 million in May. These accounts feature no-commission trades and the ability to buy fractional shares.

This makes the 1990s “day trading” craze that ran concurrently with the dot-com boom look downright tame.

And we know what happened then. Alan Greenspan, chair of the U.S. Federal Reserve at the time, warned of “irrational exuberance” in the markets. He was right on the money.

If you don’t remember, those day traders – retail investors who fancied themselves professional traders simply because they were onto hot, momentum-driven dot-com shares – helped take those stocks to nosebleed levels, where they stayed…

… until the “Tech Wreck” took the tech-heavy NASDAQ Composite down 85.6%.

That was the end of a lot of frothy tech companies and, for a time, the day trading craze.

Now a feedback loop has brought day trading back in a major way, but with a bit of a twist.

This time around, professionals have been chasing the freshly minted traders – the “FOMO crowd.” New investors, gripped with a fear of missing out, have been bidding stocks to insane heights since the March “coronavirus crash,” and pros have been right there with them.

These new investors have been “scooping up bargains” on stocks that are cheap in dollar terms, but could be wildly overvalued at a fundamental level. We saw this happen back in April after oil crashed, and millions of people moved on oil exchange-traded funds (ETFs) they didn’t understand and, worse, due to market mechanics, didn’t even track the price of oil correctly at time.

That said, there’s still a ton of institutional money on the sidelines; maybe as much as $1.5 trillion has missed the rally, which could cushion any market sell-off.

But the possibility that we may not have been through pandemic’s worst effects yet is suggesting to folks that stocks could be waaaay overvalued, which causes panic selling in the retail crowd… which leads everyone lower.

Every time there’s some good news on the pandemic – a promising vaccine candidate, a downward move in hospitalizations, some positive change in our understanding of how the virus works – those retail investors chase beaten-down stocks. They bid up airlines, cruise lines, banks, or cyclicals, and send them up double-digits in a day.

Come negative or uncertain news, and they panic and sell those same stocks, driving them down double-digits in a day.

Retail investors sold on Thursday. And they bought on Friday. Futures lurched lower in pre-market trading yesterday, and buyers started to come back, in smaller numbers, at midday.

The big question facing investors now is whether those new investors will freak out if it’s proven the pandemic is still a dire threat. If so, the same market they drove higher will come crashing down around their ears.

We’re about to find out.

The Market’s Immediate Future Hinges on This One Thing

The Dow fell 6.9% on Thursday last week. That’s scary. For the week, it was down 5.55%. That’s a big hit.

The S&P 500 lost 4.78% last week and the NASDAQ Composite lost 2.3% within a day or so of its hitting all-time highs.

That was rough, but nothing compared to what the Russell 2000 index of domestic small-caps did. The Russell declined 7.6% on Thursday – 11.8% for the week. That’s a textbook, bona fide correction.

There are two things I think could happen from here.

The same fresh-faced retail investors who sparked the sell-off in the first place could very well turn around and, gripped by a “buy the dips” fever, bid those stocks back up. Yes, you read that correctly: The people who sold on Monday could turn around and buy on Tuesday or Wednesday. That’s why they call it “irrational” exuberance.

There’s that $1.5 trillion in institutional money I mentioned, too. That money may not be tempted by dips. It’s very possible they’ll take a pass at a sliding market and wait it out till overvalued markets come back down to where they think prices should be.

If that’s the case, we could be in for a rough ride.

The bottom line is this: For the time being, the market is going to live or die based on the reaction of hordes of new, inexperienced investors to headlines – headlines that could be positive or negative.

Investors will want to move accordingly. This is a classic trader’s market: Don’t succumb to the FOMO that’s got even professional investors swept up. Be selective if and when deciding to go short or long. Make sure you’ve got “mental stops” in place; those aren’t actual orders, but price levels you’ve got in mind to get out of positions that have gone against you.

Strength – real strength, not frothy foam – will come back into the markets eventually; the bulls will have solid ground to run, but until then… you’ve been warned.

— Shah Gilani

Source: Money Morning