What is it about human nature? Why won’t we learn from history but keep believing that things are going to be different this time?
I’ve been a hobby stock investor for 10 years now. I’ve lost a lot — and I’ve won a little bit more than I’ve lost. So you are probably not going to find the path to wealth by reading the paragraphs below.
But what I have slowly discovered over the years is that the market is not rational. At all. Contrary to what I had been taught about the market always being right, the market is in fact whimsical, vain, nervous and presumptuous. In short, it’s irrational.
A key reason for this is that the market is made up of people who believe themselves to be ‘investors’ but are in fact something else entirely. Some of these ‘investors’ shun the so-called ‘daytraders’ that buy and sell stocks within extremely short time spans. The longer term ‘investor’, on the other hand, takes time to analyse and consider a stock — and hang on to it for longer, months or years, before selling it again. The ‘investor’ considers the ‘daytrader’ a mere speculator, while in fact he is himself exactly the same: a ‘speculator’.
In the true sense of the word, the term ‘investor’ is best applied to a person who hands over money to another person, or company, in the belief that this other person will do some good with the money. Create something with it and make the money grow, basically, to mutual benefit.
But if you buy stocks that already exist, you are basically trading in used goods. The money paid is not going to a business owner who will use it to make something grow. The manufacturer of the good, the company that issued the stock, was paid long ago in the first sale of that stock. Now that piece of paper is solely being exchanged by merchants hoping to make a profit. In other words, the ‘investment’ was made a long time ago. After that first sale, the stock will, forever more, be a piece of paper that is purely the object of merchant’s speculation: Will it go up or will it go down. And this is regardless of whether the merchant sells two hours, or two years, after buying the stock.
This is the way the market functions, and that’s fine. The mechanisms put value on entities that could otherwise be very difficult to value. So the market serves an important purpose.
Birds flying? Or holding on to horses?
But if the market is made up of profit-hunting merchants, of people, existing methods of analysis appear to have their shortcomings.
When I first started out “playing” with stocks, I learnt the terms TA and FA — for Technical and Fundamental Analysis. As you probably know if you are reading this, TA deals with the data from the actual trading of the stock (the fluctuations in the price, the trade volume etc.), while FA basically looks at what the company is actually doing and to what degree those doings appear likely to result in earnings in the future.
But what about PA? Psychological Analysis? The term popped up in my head after having traded stocks for less than a year. Eager to learn, I took part in discussions on an online stock forum, and observed how fascinatingly irrational people were about what they spent their money on:
“Oh, the bird is gonna fly now, see you on the other side of 500.” (while the price of the stock was at 340 and there was nothing particularly interesting happening at the company in question)
“They are going to crash hard. Hold on to your horses, we are going down. All the way.” (about a company that had lost a fairly small order, and the stock was down a couple of percent that day)
Now, most of the people debating stocks on the forum were amateurs (private “investors”), and the bulk of trading is done by professionals (banks, pension funds etc.). But they are all people — apart from the automated trading done by some software, but that’s another story. And all these people are whimsical, vain, nervous and presumptuous. Just like all people are. And so the market becomes the same: It overreacts. It gets cocky, chases profits and drives prices too high. It gets nervous, panics, overcompensates and pushes prices too low.
This, of course, is why we see the little fluctuations in stock price charts. Up and down. Up and down. There’s even a name for speculators trying to hit the highs and lows of these little blips: swing traders.
But sometimes these blips are a lot more than blips. Sometimes they are insanely optimistic stock frenzies that drive prices way up high. Sometimes they are panics that can only see armageddon, fire from the sky and imminent death, up ahead.
This is nothing new either. It’s the cyclical nature of the stock market. But having been through the extreme highs of 2004-2007, and the extreme lows of 2008-2009, it’s been fascinating to see exactly how wildly the market overreacts. It’s utterly irrational. And this happens even though everybody of course knows, deep down anyway, that the market is cyclical and no, the world is probably not going to come to a complete halt and, yes, the stocks will bounce back up (or come back down). But it doesn’t help. The market is too complex and too controlled by the sum of human emotions to be rational.
This is why I believe PA is the strongest tool in your box. FA and TA, fine. The real world matters, of course. But I’ll continue to pay significant attention to PA in the future. Do you sense a panic brewing? Or is everybody riding the birds with their eyes set on the Sun?
Catching knives and healing cuts
The strategy is best applied on a macro level. Somebody has possibly told you not to try to catch falling knives, but that mainly applies to individual stocks, not the market as such, I believe. Not if you are patient anyway. That knife may cut you a bit initially, but if you grab it, it will slowly, magically, lift itself out of your hand.
Best time to get in is while the market is still falling but the panic seems to have settled a little bit. Best time to get out is when the birds have been flying too high and the index value is disproportionate with the average developments in the past.
Below is a chart displaying the American S&P 500 index over the past 25 year. You can use the Dow Jones instead, if you will, it looks pretty much the same. Or the German DAX. Or another. Doesn’t matter. The Western economies move pretty much hand in hand today.
The red line is my doing. It is completely, 100% unscientific but it is, in hindsight, an indicator of a how a more rational market might have evolved. But the real market, of course, is irrational. Not even the sky was a limit when the dot com bubble built in the late 90s. When it burst, the purgatory awaited.
Looking at the chart, the index was way off the red line in 1999, but it continued growing until the dot com bubble burst and dragged it down — later aided by concerns following 9/11. The bubble of 2007 burst with an even louder bang, of course, dropping from 1300 to below 700 in about 6 months (the deepest dip is not visible on the graph above).
It has happened before, of course. The 20th century is littered with bubbles and bursts. But we will not learn, because we are irrational and because we speculate and want the market to be a money machine. The ‘speculator’, and we all are, has no real interest in the value of the market being an accurate representation of financial realities. The market is primarily an instrument to make money. An instrument that nobody wants to see break. So it will happen again and again. And the calm, rational ‘investor’ should know this and anticipate this.
Time for panic?
Looking at the chart above, it seems like we have moved deep into bubble territory again — not least fuelled by central bank QE (quantitative easing), by good news seeming so much better when they happen after years of economical gloom and, as always, by irrationality. Personally, I have sold most of my stocks and plan to sell the rest very soon. We are headed for panic — or for a ‘correction’ as it’s sometimes referred to. Some rational observers believe this correction could be anywhere between 10 and 20%. That’s probably true looking slightly further ahead, but I believe it could bottom out at as much as 35% lower than where we are today (1,932). This would correlate pretty well with the panics of 2000-2003 and 2008-2009 and it would mean we’d end up at around 1250 which is still pretty high compared to the dip to around 700 in 2009.
The S&P 500 has grown from 676 in March 2009 to 1,932 today. That’s almost a 290% increase in just over five years. During the same time, the US real GDP grew less than 10%!
I’m going cash and buying again when the panic starts to settle.
Time to end today’s post. Let me just point out that observing market psychology, or madness if you will, and buying and selling accordingly, can also be applied on stock-level. It’s not quite as efficient because on this level FA holds more importance: Is the company actually doing any good?
On the macro market level, things are different, because the market will never die. That would be the same as humans seizing to do anything. And humans basically want to do things. To build, grow and prosper. So on a macro level, all blips are just blips. With real effects on people, of course, but they will always correct themselves in the long run.
On a company level, things really can go wrong — or extremely well. But irrational fluctuations still occur on a grand scale.
Let’s take Apple as an example. Here’s the stock price from late 2009.
In early 2012, the bubble started forming. In september it burst and, as it so often happens, the market “over-corrected” and almost halved the stock because some were concerned about the level of innovation in the company and cried wolf. It halved!
I bought the stock at 75, convinced it was another over reaction. A bit too soon, it turned out, but I’m still sitting on it and today we’ve almost reached early 2012 levels. Hanging on is the key to catching knives.
At some point in the months ahead, someone will cry wolf, and the wolf will come. Called upon by the noise made by everybody crying its name. The market will come down … and come up again.
I’m gonna catch some knives and then hang on.
NOTE: I have half a BSc in business economics, but I primarily work in communications, and what I have written above are merely a few casual Sunday thoughts. Apply this thinking to your own trading at your own risk. Who knows, maybe this time the stocks will not come up again and human activity will cease …