Investment Psychology Explained Read online

  Best-Selling Books

  When trying to form a contrary opinion, it is very important to attempt to gauge the mood of the general public. The media can provide us with some useful clues but some of the best signals of all come from the best-seller list.

  Perhaps the first indicator in this direction occurred in the 1920s at the height of the bull market when Common Stocks as Long-Term Investments, by Edgar Lawrence Smith, saw widespread approval. The thesis of the book was that over the long haul stocks had outperformed bonds and that is where investors should put their money. His argument has been proved to be correct since that time because stocks have continued to outperform bonds since 1929. The problem was that the book's popularity indicated that the general public obviously understood the bullish argument for equities. In the next decade, bonds handsomely outperformed stocks.

  Best-seller signals of this nature do not come around very often, largely because market trends do not move to a manic extreme that frequently. Adam Smith's Money Game was a classic in that respect, reaching the best-seller list at the time of the speculative stock market bubble in 1868. William Donahue's book on money market funds in the early 1980s hit the best-seller list right at the period of the postwar peak in interest rates. It represents a classic indicator of a fairly technical book that would not normally be expected to sell more than a few thousand copies. Yet it reached the best-seller list and in doing so indicated that the public was probably reaching a peak in its desire for money market funds. I do not mean to cast any aspersions on the book but merely draw your attention to its unusual and unexpected success.

  Another book that caught the attention of the public was Ravi Batra's forecast of a major depression right at the time of the 1987 crash. As it turned out, the market, far from declining, managed to rally over the next few years, doubling in price from its crash lows.

  Sentiment Indicators

  A final avenue that we need to cover in our quest for a more timely basis on which to form a contrary opinion is data obtained from polling various professionals about their views. Investor's Intelligence, * founded by the late Abe Cohen, pioneered the approach of gauging how many of the numerous newsletters he read were bullish or bearish on the market. These data have been available on a continuous basis since the early 1960s. The results for more recent years have been plotted in Figure 8-2 and compared with the market's performance. The concept is quite simple. When the majority of market letter writers are bullish, it represents a danger signal so it is time to think about selling, and vice versa. The chart shows that this is easier said than done, because there are many periods such as mid-1985 and mid-1986 when people were bullish and yet the market did not decline, and those such as early 1990 when most investors were bearish yet the market did not rally. The indicator, then, is far from perfect. Sometimes it is right on the mark and sometimes very early. It therefore makes more sense to use it as a complement to other measures of market sentiment and contrary opinion.

  Figure 8-2 S&P Composite versus Advisory Sentiment 1984-1991 (10-Week Moving Average of Bulls Divided by Bulls + Bears). Source: Pring Market Review.

  Figure 8-3 shows another sentiment indicator. Published by Market Vane, this is a four-week moving average of the percentage of bond traders who are market bulls. The published data are expressed on a percentage basis. I have subtracted 50 from the total so the resulting series moves from positive to negative territory. The opinions expressed in this survey are of a far shorter time horizon than the Investor Intelligence data and therefore are significantly more volatile. They match the swings in bond prices quite well, but it is difficult to obtain a precise timing device from this activity. In short, such data need to be combined with other indicators and approaches if a meaningful use is to be made of it.

  Figure 8-3 Lehman Bond Index and Bullish Bond Consensus 19851992. Chart Source: Pring Market Review. Source for Bullish Consensus: Market Vane's poll of futures-trading advisors, Haddaday Publications, Pasadena, CA 91101.

  Sentiment at the End of Recessions

  I mentioned in an earlier chapter that it pays to be skeptical when reading comments volunteered by "experts" because such prognostications can often be misleading. In the January 1992 edition of the Bank Credit Analyst, * the editors researched several publications to find out what was being said at the end of the 1969-1970, 1973-1974, and 1981-1982 recessions.

  1969-1970

  The jobs picture continues to deteriorate-almost every major industry cut back on its work force in October. . . . The October numbers are worse than they look. Business Week, November 14, 1970

  Business statistics of current activity look sour-so do those which point to prospective activity. Orders for durable goods are dismal. . . . There are few (businesspeople) who expect an economic turnaround before the end of 1971. Business Week, November 28, 1970

  The (staff) projections still suggested that the average rate of growth in real GNP over the three quarters ending in mid-1971 would be relatively low. Minutes of the December 15, 1970, meeting of the Federal Open Market Committee

  Mr. Paul McCracken (head of the Council of Economic Advisers) is telling everyone-including the President-that the job of restimulating the economy next year will be more difficult than most people had thought. . . . (There is) strength in housing construction and in spending by state and local governments, but sluggishness elsewhere. The Economist, December 19, 1970

  The editor noted, "The recession trough was recorded in November 1970. Real GNP rose by 91/2% between the fourth quarters of 1970 and 1971."

  1974-1975

  The decline in industrial production is particularly worrying because it is still on an accelerating trend, and it can no longer be pinned on any single industrial sector. . . . Low interest rates have done nothing for the money supply which has dipped marginally in the past two months. The economy, frighteningly, seems to be going its own way, shrugging off the help being doled out to it by the Administration. The Economist, February 22, 1975

  Whenever the upturn in the American economy comes it will not, according to even the most optimistic predictions, be before summer. That means at least four more months of dire economic statistics telling much the same story of deepening recession as the latest February figures. . . . While the Federal reserve is proudly trumpeting its apparent victory over inflation, its worry is how to pump enough money back into the economy. If the private sector is not going to take the lead, then the government must. Congress itself is playing with increasingly generous sums to inject into the economy. The Economist, March 15, 1975

  The information reviewed at this meeting suggested that real output of goods and services was continuing to fall sharply in the first quarter of 1975. . .. Staff projections, like those of a month earlier, suggested that real economic activity would recede further in the second quarter. . . . Minutes of the March 18, 1975, meeting of the Federal Open Market Committee

  A sharp contraction in employment in February indicates that the production decline and inventory readjustment is proceeding rapidly; there is scant evidence of an impending improvement in business. . . . There is little question that the labor market is deteriorating. . . . Moreover, the contraction in jobs is widespread, suggesting that further declines lie ahead. Business Week, March 24, 1975

  It is yet far from clear when the recession will bottom out and how far down the low point will be. Business Week, April 7, 1975

  The editor's note read, "The recession reached a bottom in March 1975. Real GNP rose by 13'/2% between the first quarters of 1975 and 1976."

  1981-1982

  The Fed's view is that without some stimulus, economic activity will not pick up in the near future. The 1% rise in retail sales in September was mostly clearance sales of cut-price cars. Consumer confidence is low and spending is slack. The Economist, October 16, 1982

  The battered economy isn't picking up yet. There are still very few signs that business activity is improving. On balance, in fact, it looks as if t
he decline in manufacturing is still not over. Business Week, November 8, 1982

  The staff projections . . . suggested that real GNP would grow moderately during 1983, but that any recovery in the months just ahead was likely to be quite limited. . . . Many members continued to stress that there were substantial risks of a shortfall from the projection. Considerable emphasis was given to the widespread signs of weakness in economic activity and to the continuing absence of evidence that an economic recovery might be under way. Minutes of the November 16, 1982, meeting of the Federal Open Market Committee.

  The data have been suggesting it for weeks. There is as yet no general recovery in business. To confirm it, the fourth quarter started off on the downside. Business Week, November 29, 1982

  Across the nation, the bottom is dropping out of the budgets of state and local governments. . . . The result is likely to be new rounds of spending cuts, layoffs and tax increases despite efforts to adjust to rising unemployment and falling federal aid during the past two years. Business Week, November 29, 1982

  The editor noted, "The recession reached a bottom in November 1982. Real GNP rose by 10'/2% between the fourth quarters of 1982 and 1983. State and local finances improved dramatically in 1983.

  The average person taking these comments at face value would be badly misled. On the other hand, the contrarian, taking a more skeptical line, would see them as an established viewpoint deserving of consideration from the opposite perspective. The quotations are self-explanatory and stand on their own. Figure 8-4 shows when the comments were made and what happened to the economy and stock market afterward.

  Summary

  Forming a contrary viewpoint for exact timing purposes is a difficult task. In this respect, we need to combine a study of the media and the attitudes of friends and associates together with indicators such as valuation that give a good historical perspective of when an extreme has been reached. When all the pieces are more or less consistent and it is possible to come up with some alternative and credible scenarios, the chances are that the market or stock in question is about to reverse its prevailing trend.

  Figure 8-4 Economic Forecasts versus the Commerce Department's Coincident Indicators and the Stock Market. Source: Pring Market Review.

  How to Profit

  from Newsbreaks

  From time to time, you may have heard or read a news account of a market development along these lines: "Despite a jump in the discount rate, stocks rallied sharply on Wall Street," or, "IBM announced today that earnings were up 10%, but IBM shares declined by $1.50. Analysts were at a loss to account for this reaction." These reports are typical of the way any market might react to news. This type of seemingly irrational price action is certainly not the sort of thing that a logical person would expect to happen, though. If the news is good, presumably the stock should go up, and if it's bad, certainly then it should go down.

  These seemingly inexplicable reactions occur because the market, or, we should say, market participants, are always looking ahead and anticipating all facets of the news and the events behind the headlines. Consequently, when the IBM earnings were announced, the figure was something that most observers had expected, and so they had already bought the stock. Some, who were not aware of the "good news," decided to purchase on the announcement. Others, however, had been waiting for that exact moment to unload the stock and used the IBM earnings report as an excuse to sell.

  Occasionally, these types of announcements will generate greater buying strength, in which case the stock may close the trading day up in value, but probably well down from the high achieved just after the announcement. No matter. Most people expected the news and had decided to use the event to unload stock on those individuals or institutions who were unexpectedly impressed with the earnings report. Why? Perhaps these same investors believed that this represented a peak in earnings for a while. The announcement was therefore a God-given chance to sell into strength at a very favorable price. In any event, from the point of view of the market observer, the key is that the news was good and therefore the stock ought to have risen in value. That it didn't was a sign of weakness. After all, if the price is unable to rally on good news what would induce it to go up? This is a very difficult concept for most people to grasp, even those with many years of experience in the markets. If the news is good at the time, it always seems foolish to sell, but in retrospect that is usually the smart thing to do.

  On the day of the August 1991 coup against President Gorbachev in the former Soviet Union, the gold price ran up $4 to $6 during the morning but closed the day in New York only 50 cents higher than its value at the start of the day. This was two days before the coup collapsed, so there was still plenty to worry about. Few observers would have guessed at the time that the revolt would soon be over. The gold price, which was moderately oversold at the time, ought to have had a field day since it almost always responds positively to disquieting world events.

  In the inflationary 1970s, such news could have been expected to result in a $20 to $30 increase. As that first day of the coup came to an end, there was a great deal of uncertainty and the price barely budged. The event was totally unexpected by the market, so it could not be argued that the coup had been factored into the price. No, there was clearly something bearish in the supply-demand relationship. Buyers were not being enticed back into the market by this "bullish" news for the metal, but sellers were there ready to offer all the gold that anyone wanted. The failure of the price to rally on the news was a bearish sign. Later that week the coup failed, and the price continued on its way down. Figure 9-1 shows that it did not decline that much and eventually returned to the precoup levels, but from a short-term point of view, selling on "good" news was the correct thing to do.

  News Known Is News Discounted

  All financial markets look ahead in an attempt to anticipate future events. This practice is called "discounting." At first, this process involves a few farsighted individuals who have a good sense of the chronological sequence of events that usually transpires in a typical market cycle. Such individuals also have experience in gauging how the perceptions of other market participants might change as events unfold. As time passes, the probable outcome becomes more widely expected and therefore discounted by more and more people. Finally, the event takes place or is announced, and participants start to anticipate the next one. This is a simplification of what actually takes place, since prices are determined by the interaction of a number of different events, economic trends, and psychological background factors. If it were possible to isolate the discounting mechanism to one or two events, forecasting any market would be a relatively simple matter because everyone would play the same game, meaning that the discounting process would be instantaneous.

  Figure 9-1 The Gold Price 1991. Source: Pring Market Review.

  Academicians have long claimed that financial markets are efficient. The efficient-market theory states that a specific market or security digests all the information likely to affect it, so that this knowledge is immediately and efficiently factored into the current price. Proponents of the theory claim that it is not possible to make money in the markets by anticipating events because they are in effect already accounted for in the prices. The markets, they conclude, are therefore a "random walk."

  I cannot disagree with the hypothesis that markets are to some extent efficient. Anyone who believes that the earnings of his favorite stock are going to plunge would be illogical if he did not sell at least part of his position and buy it back later at a more favorable price. There are two flaws in the efficient-market hypothesis. First the same information is not given to everyone at the same time. News takes time before it can be widely disseminated. Second, not everyone will interpret the information the same way when it is received. Remember, for example, how most people take the news at face value, while the contrarian will look behind the headlines to see whether there are any reasonable, alternative scenarios to those being followed by the crowd. />
  Let's take the example of XYZ stock. For the past six months, XYZ has been trading in the $10 to $12 range. One particularly bright analyst discovers that the company will soon be in a position to cut costs dramatically because of a new product that it is about to introduce to the market. As a result, he starts to recommend the stock to a few of his select clients. This incremental demand is enough to push its price above that $10 to $12 trading range. Other analysts gradually pick up the scent, and the price advances a little further. Then the company announces some unexpectedly bad earnings, and the price slides. Miraculously, the decline is very brief, and the price again resumes its advance. This occurs because the knowledgeable people who are aware of the forthcoming development see the decline as an unexpected opportunity to pick up some stock at what they consider to be bargain prices. One of the key points to grasp here is that a market or a stock that can quickly absorb bad news is usually in a strong technical position. Such action in effect represents a very positive sign.

  Later, more investors begin to hear about the company as retail brokers spread the news to their customers. During this whole period, the price continues to advance. Consequently, by the time the company is ready to make the announcement, almost everyone is expecting it, so the news comes as no surprise. When the product introduction finally appears in the newspapers, the event is common knowledge. Only newspaper readers who have not previously been privy to the information are likely to be buyers. After that point, there is no one left who is likely to make a purchase based on the news.