Tuesday, July 15, 2008

Negative Expectations at Their Highest in History

Our MarketPsych index of negative stock market expectations is now the highest we've ever seen (we've got data back to 1984).

The Fed's actions and words -- explicitly committing to bail out mortgage lenders -- should have lowered market negativity. Instead we got a morning rally afterwards and then further selling.

What we saw last week was everyone jumping ship - a real crowd effect. The only information driving investors was downwards price action and rumors of further collapses. The more stocks dropped, the more they sold. A positive feedback loop was created.

In psychology, a positive feedback loop is created when people base their opinion of how bad a situation is on the actions of others. When everyone is doing this, we can usually call it the peak of a mania or the bottom of a panic.

The market stopped being comforted by the Fed, which is a bit scary. Fortunately, it was primarily the financials getting hit today. The Biotech index was actually up 4%. A rally is certainly near (though I was wrong last week).

Eventually, when the supply of sellers decreases, because they've run out of shares or capital to sell, positive feedback loops can't sustain their negative price momentum.

The danger is that acting on negative expectations can become a self-fulfilling prophecy. I wrote about this in my book, with the example of Brazil's near debt default in 2002.

Essentially, the more investors avoid new bond offerings, and the higher rates go (especially for junk bonds), the more squeezed are companies that need to raise capital. Eventually many will go bust because they can't afford the high interest rates (which are high because investors are afraid the companies will default). If the rates had been lower (because investors were more calm), then the debt would have been service-able and the company would have survived. The crowd's pessimism really can make things worse (just as its optimism was problematic in allowing such overconfident risk taking through 2007).

At this point, it's important to ask "can it get worse?" (yes), "will it get worse?" (probably), and "has this been priced in?" (in many sectors, yes, much too much).

In financials it's not clear to me if it has been priced in, hmmm.... A rally in financials won't happen until we know where the next bogeyman is. And right now, there are lots of terrible rumors, but no new sources of pain. I think investors are waiting to see how the current pain will spread, since it's clear that the economy is slowing and the real economic slowdown hasn't been reflected in the numbers yet. "Who's next to collapse?" is often heard.

There are some amazing bargains out there. A stock or bond screen will demonstrate great values. I don't trust the numbers on financials (never have), but in some traditional industries low debt stocks with PEs of 6 and trading under their book values are much more common. I won't get specific because the blog is about psychology, not stocks picks at the moment.

But watch out for stocks vulnerable to the self-fulfilling prophecy of higher interest rates for "risky" bonds. That's whay I mentioned to look for "low debt" stocks.

Solutions to the current crisis include better political and regulatory management of the psychology of risk-taking, which isn't likely anytime soon (as I mentioned in my last blog post). It will take some deep understanding of human behavior in the Fed and SEC (and maybe an in-house psychologist or two) before we get such enlightened policy. In the meantme, there will always be bubbles and panics to take advantage of.

Historic times we're in. Now let's make the best of it!



crazyfirdayman said...

Hey, you have some interesting views here. I'm in the UK but regardless of this your comments can be applied. I've studied psychology myself and was trying to find a formal course on Investor Psychology, or financial or whatever name it might come under. Seems like it's not caught on yet.
I'm gonna keep an eye on your BLOG, it's interesting stuff.

Anonymous said...

While we saw panic selling on Tuesday followed by rallies for two days, the markets for indices are back to choppy mode.

Tough to read when the markets have bottomed.