The Psychology of Fear

When markets become volatile (the media euphemism for declines) fear often takes hold.  In this environment investors and traders who are operating on "feel" or advice from media sources often react emotionally.  Dr. Brett Steenbarger, who writes extensively and expertly on these subjects identifies the operating elements today in his article on how to handle volatile markets.  As usual, Dr. Brett draws upon scientific literature, in this case from neuroeconomics, to describe the biases we all face.  Everyone should read his article and follow his links to get a better understanding of the problem.  Whether or not one agrees with our particular approach, it is important to proceed from reasoning and not from emotion.

Last week we addressed this problem, but it deserves further analysis.  We look today at the general issue, but will try to provides some specific stock examples in future posts.

How Fear Develops

1. There is a background of frightening forecasts.  This goes with the territory.  Some of those writing have short positions and want to cash in.  Others are promoting their blog or their book, catering to a specific audience.  Even though the forecasts may have been incorrect for months (or even years) their audience is primed.
2. Something happens that seems to validate the hypothesis.  Quantification and formal modeling is not necessary.  Anecdotal evidence is sufficient to gain attention.
3. Mainstream media pick up the story.  This is a natural result of the need to "explain" any market move.
4. Technical analysts point to the market moves as validation of a new trend, breaking of support, and deep insight into the future.  It is interpreted as a message from the market.

In short, an initial move in the market (or in specific stocks) is interpreted as a validation of a theory.  This can take place even when the theory itself has limited factual support.  (Last year we described an interesting example of this knee-jerk reaction in a specific stock, Intel, when media coverage presented an opportunity.)

The Current Issues

The current selling relates to two major issues, the sub-prime mortgage market and the yen "carry trade".  The question for a rational trader or investor is whether these are phenomena that are limited and localized, or whether the issues extend to many stocks and the market in general.

Those promoting fear suggest that the problems of a few companies that were too aggressive in lending is a harbinger of overall economic weakness.  They do not have a formal model or any quantification, but use slogans like "a fungus among us" and imply that that major financial institutions are threatened by bad loans.  When management of these firms assert that their loan portfolios are sound, the fear promoters are skeptical.  They believe that CEO's ignore Sarbannes-Oxley requirements and risk legal sanctions to hype their businesses.  They see the worst, even when earnings records are solid.  These vocal bloggers and pundits are mired in the 2000 era -- fighting the last war.

Finding some Clarity

At "A Dash" we pride ourselves in finding the real experts on any topic.  Often this means placing little reliance in bloggers who take pride in never studying economics and looking to those who have a proven record and a great feel for current conditions.

Rich Karlgaard's column today presented a fresh piece of analysis from David Malpass.  When he gets permission to reproduce Malpass's proprietary work (which we always read and often quote), everyone should jump at the chance to read the entire piece.  It is well worth the time.  Here is the key quotation:

We disagree with the view that the U.S. expansion is fragile due to housing, mortgages or past rate hikes.  Since 2003, housing-related industries have accounted for only 4% of the 7 million in net new jobs (including residential construction, mortgage brokers and Realtors).  Mortgage equity withdrawals have substantial correlation to net acquisitions of financial assets but little correlation to consumption (as shown clearly in 2006's weak MEW and weak net acquisitions versus strong consumption growth).  The economy grew steadily through 17 interest rate hikes, arguing that it may turn out to be sensitive to the level of interest rates but was not very sensitive to rate hikes from low levels.

For anyone who chooses to look at evidence rather than to react emotionally, this means that the market is punishing stocks that are sensitive to economic growth.  (Obvious full disclosure:  We own such stocks and we are buying into the decline).

Malpass wrote another piece, not reported on the Karlgaard site, showing the relatively small proportion of global liquidity linked to the yen carry trade.  While it seems obvious to us that those borrowing in yen and using eight or ten times leverage are buying bonds, not investing in Caterpillar or FedEx, the current market reflects a different viewpoint.

Forming a Plan

Mr. Market is offering investors an opportunity to buy good companies at discounted prices.  My most astute long-term investors are adding to positions.

For traders the problem is trickier.  Part of the reason for the current decline is that traders are waiting to see when these stocks -- and the market -- will catch a bid.  The trading problem involves guessing the psychology of others as well as being right on the fundamentals.

It is still helpful for the trader to understand the dynamics and be prepared for action. 

Comments

[oldprof]

Mr. X -- Thanks for your comment. You have your finger on the key issue: future earnings growth.

We simply do not agree about whether or not current earnings are at a peak. I am curious about your evidence for this and why you are so confident that a market cycle must be four years. Enter these as search terms (like forward earnings) for the site, and you'll find a lot of information to consider.

As to the "documented slow down" in next year's earnings, we must be careful. I agree that profits will not grow at a double-digit rate forever, but that is not necessary. The market still has a lot of catching up to do from the last three years, and next year's earnings forecast is OK. There is nothing wrong with growth at the historic average.

Thanks again for making a point that is probably on the minds of many. A more complete discussion of the peak earnings theory is on my agenda.

Jeff

[Mr. X]

"Mr. Market is offering investors an opportunity to buy good companies at discounted prices."

True, but the adjective 'expensive' needs to precede 'discounted'. Stocks are at peak earnings now after a four year bull market, and price-to-earnings ratios are bound to rise in light of the documented slow down in next quarter's (and next year's) earnings estimates. Buyers of stocks at these levels need to be aware of where we are in the earnings cycle.

[marlyn trades]

You nailed it again Jeff - it is so nice not to read "the 10 myths about the meltdown" and other ill-informed garbage. I don't study economics but I basically said the same thing you did the other day in one of my posts. I figured it out on my own because you won't get any real information from CNBC - it's too complicated for the Cramer nation.

[Shrek]

Why do you keep citing backword looking economic data? The market discounts the future. You guys are a perma bull blog whether you realize it or not.