Expectations, the Stock Market, and The Prediction Addiction

Why is it so tempting to make stock market predictions?

Maybe it's an anxiety reliever -- predicting implies that there is a pattern, a cause, that can be found if only we look hard enough. Forecasting bolsters our sense of control.

At the same time, we all predict with similar neural "hardware." So maybe we all make predictions based on similar information, or at similar times? And if so, are we collectively usually wrong or right?

The answers to that question underlie our asset management service (MarketPsy Capital LLC).

The chart below displays negative expectations in the major business press (WSJ, Financial Times, Barrons, New York Times).



The chart shows Negative stock market expectations (the brown line) superimposed on a candlestick stock chart of the S&P 500 (SPY). As you can see in the chart, high negative expectations are not usually a good time to buy, until they fall.

Today negative expectations dropped when the Fed reported a willingness to lend to banks beyond September 2008.

However, creating a portfolio strategy out of the "buy on decreasing negativity" insight is not easy. For one thing, we can intellectualize and chart our pessimism, but we still believe it: "this time it's different, it really is THAT bad," we might tell ourselves.

And furthermore, somtimes negativity is justified, and the catastrophe really does happen.

Here is a chart of the same data series from a January blog post. Notice that we did get a stock market rally when the negativity decreased, but now it is higher than perviously.

The stock market is an anticipatory mechanism. It has priced in a lot of pain to come. The real question is, will the pain be worse than the market expects? If not, then it is likely to rally. And in general, people anticipate more pain than is actually experienced. They will even cause themselves greater pain in the present so they can stop anticipating future (smaller) pain. (This is called the cost of Dread). Many investors felt tempted to sell their stocks last week, just to save themselves the dread of further price declines.

This Fall we'll see if the credit crunch shows signs of abating. From what I hear and read (The Credit Crisis is Going to Get Worse), it will continue. And printing money (increasing liquidity) may not work as well in alleviating the squeeze this time.

That said -- and because I'm nervous about this market ;) -- I'd like to make a prediction. It's kind of a cheap sensationalist substitute for an educational blog post. Like the one that Frank just wrote. But here goes: I suspect we're due for another short-term rally. Expectations are vey pessimistic, and now they are becoming less so.

Those are my thoughts, but then, maybe I'm just seeing order in madness. On the contrary, given the statistical results of our research, I think we really have found predictive factors rooted in the collective psyche.

It was clever that Bernanke spoke about continuing debt relief today. Someday, I'm optimistic, the Fed will consciously direct fiscal, policy, and monetary factors to have a greater impact on the psychology of the economy's participants. This may help alleviate future bubbles and crashes.

But that may require a generational change, and I don't think we have enough evidence that it will not also do harm (though it can't be much worse than the enormous liquidity we've seen in the last decade). It's not easy to accurately model psychology or economic behavior, which keeps it out of the standard curriculum.

For now, we are seeing efforts to change fiscal policy that do have a positive effect on the psychology of consumers. Which is good. Someday those efforts will include specific language and will target more vulnerable psychological themes (housing insecurity, confidence to spend, fears of perpetual debt, etc...).

Richard