Rally Ahoy? (again)

A short-term rally will probably happen this Spring. If so, it is a "sucker's rally."

Maybe it's a quirk of human psychology, but it seems like far too many investors buy at the high and sell at the low. It's such a common mistake that the inverse saying ("Buy high, Sell low") may be the most common in the Wall Street rule-book.

Many investors with cash may sit on the sidelines over the next few months as the stock market moves upwards. Near the high they will buy into the market, just when they can't take the pain of watching from the sidelines any longer.

We're coming off a Fear-bottom now (as Frank pointed out, the Bear-Stearns news was the straw that prompted a cleansing "capitulation"). It was "cleansing" because it knocked the weak money out of the stock market. Now strong money remains, and the race to Dow 13,000 is on again.

Why does this "Buy high and Sell low" misbehavior happen, and why is it so predictable? It seems to be one of the many mysteries of market psychology.

Richard

Nice Call, Master Yoda

Market: I'm not afraid!

Rich: You will be.... you. will. be.

Regarding your previous post, you may not have to be worried about the absence of fear for long.

The MarketPsych Fear Index has seen an uptick recently.

One reason I believe it has meandered of late is that a critical and catalyitc component was missing: The appearance of a nightmare scenario that the individual can; 1) experience viscerally, and 2) consider credible.

The Bear Stearns news today presented just such a scenario, and it sent a shockwave of fear through the markets.

We simply do not live in a world where "Modest CPI Numbers" can compete with "Wall Street Institution Imploding Overnight" in a market-moving contest.

If it sets off a "fear cascade" (think dominoes), we may just see Market Panic make it's first reappearance in years.

Getting my cash ready now...

I'm Afraid of the Absence of Fear

The MarketPsych Fear Index has been showing low Fear readings (see our Market Analysis page). This seems odd with stocks falling, the economy slowing, housing values falling, oil rising, and gold rising. Seems that inflation and low growth is coming -- a re-emergence of the old bogeyman: "Stagflation."

I double-checked this low reading by also looking at sentiment levels. Same result -- sentiment about the stock market is not so bad. I guess this makes sense considering the recent articles touting "Bargain stocks" and "Cheap shares."

The bad news, including falling stock prices, doesn't phase investors like it used to. It's like Learned Helplessness. Ironically, I'm worried by that lack of concern. It seems that investors are complacent about the bad news. As a long-time stock market investor, I've learned that we should take advantage of investor fear but avoid a complacent market.

Richard

Emotional Baggage: When it's so hard to let go...

Selling a losing stock shouldn't be hard. Yet many investors find that as bad news begins rolling in, they are in disbelief. The stock they loved has turned on them.

Take Starbucks (SBUX) for example. Last year the announcement that hot creamy drinks weren't selling as well as anticipated during the summer was a shocker to many star-struck (pardon) investors. I could hear the disbelief from investors in slow-motion withdrawal: "Starbucks can always keep growing and raising their drink prices, they just need to serve faster, colder drinks, fresher coffee, expand to Bhutan, etc..., can't they?" Yet, after Starbucks appeared on nearly every street corner, it should have seemed natural that growth had to begin slowing.

The Onion even noted in 1998 that Starbucks had begun opening Starbucks outlets in the bathrooms of existing Starbucks (see article here). To continue growing, Starbucks had to begin cannibalizing itself.

For most investors, the stages of coming to terms with a "Stock Gone South" are like those of someone dealing with other sad events in life. I cou;d even speculate that such stages might follow the logic of the Kubler-Ross model of the "Five Stages of Grief."

First, investors look for reasons why the bad news isn't really true or was maliciously fabricated by outsiders (DENIAL). If the bad news continues, then they feel ANGER (and maybe blame the management or "evil" short-sellers). Next they begin to negotiate (BARGAINING) with themselves, "I know this has been a great stock, but maybe I need to let her go for a while - I can always buy some shares again later." Unsentimental investors then sell, while the more sensitive types become indecisive - paralyzed with disappointment (DEPRESSION). If they make a habit of wallowing in self-pity, then they are likely to end up at the fifth stage of grief called ACCEPTANCE, whilst still owning the Stock as a hopeful "comeback kid" (though in reality it is likely to be sunburned pink (sheets) and panhandling for change somewhere near the equator).

At risk of jeers and taunts from those still in DENIAL, the same as is happening to SBUX might be happening to (drumroll please).... Google (GOOG)!!! Truth be told, GOOG actually looks relatively inexpensive under $450/share ... or am I too emotionally attached to see clearly? (Disclosure: I don't own GOOG shares...yet).

It might seem like an easy decision to cut GOOG loose and re-invest the money elsewhere. Unfortunately for investors there is an innate human tendency, called "the endowment effect," which unconsciously compels them to cling to familiar, fun, or long-held stocks. Associated with the endowment effect is a thought process that justifies continuing to hold a weak stock ("It's just a temporary setback;" "I'm a long-term holder;" "It's actually a good time to buy ... if only I wasn't already holding too many shares..."

We got some great evidence for the endowment effect at a training we ran for financial advisors last week. In our experiment we give out fancy "MarketPsych" pens to half the attendees (because we "forgot" to bring enough, oops!). We then decide to redistribute the pens using a market mechanism - for fairness sake. We ask those who received a pen to write down a price at which they would sell their pen (the ask), and those who did not receive a pen write down how much they would pay for one (the bid).

At our meeting last week there were NO transactions for pens among audience members, The average bid was $1.35 (which approximates the actual value of the pen). Remarkably, the average asking price was $8.80 (ranging from $3 to $15). The sample was small, and we usually see asking prices around $5, which is still remarkably high.

The high asking prices are a testament to the power of emotional attachment and its ability to cause overvaluing of those things we like (and those that are scarce). One way to increase the endowment effect, and widen the bid-ask spread, is to ask those who received a pen to describe the things they like about the pen, and to ask those without a pen to describe objective aspects of the pen. When we do that, the spread is even bigger.

So how can you fall out of love with SBUX, GOOG, or any other stock that is disappointing you? (And it usually is true that these stocks will continue underperforming going forward). Think of the objective aspects of the investment, not the ones you love to love. Don't think about how tasty frappuccinos are, think about the price to book value. Instead of remembering the pleasure you got the first time you Google'ed yourself, think of declining profit margins and ad revenues. It requires deliberate action, but it is definitely possible to toss aside your emotional baggage and learn to see stocks more rationally. It's just not very fun...

Happy Investing!
Richard