Crowd Psychology – October 2009

October 27, 2009

Dow Jones Average: 9,896
S & P 500 Index: 1,067


 

Crowd Psychology
 

Financial markets around the world endured fifteen months of selling pressure before bottoming out in March 2009. The spring rally was wobbly at first, but gained strength through the summer and early fall. Most observers have been surprised by the persistence and magnitude of the rally, because the dramatic change in investor sentiment has been accompanied by only a small improvement in underlying economic conditions.

The pronounced shift in investor attitude can be largely attributed to the psychology of crowds. When Lehman Brothers, Fannie Mae, AIG, and other pillars of the financial system collapsed in 2008, investors fled the market en masse. It was as if a great white shark had attacked the financial market, sending all those in the investment waters scrambling to the beach for safety. By early March 2009 fear thoroughly dominated the markets, with most investors expecting mass bankruptcies and a depression. The perception of imminent doom was way ahead of reality. Sensing a buying opportunity, some braver souls jumped back into the financial waters. When nothing bad happened to those early buyers, others waded in, assuming the threat had passed.

The stock market rally that started in March of this year gained considerable momentum in the latest quarter. Even though most people would agree that paying less for a stock is more sensible than paying more, rising prices always embolden investors. Over short time periods, investor behavior is driven more by emotion than logic. As stock prices escalate and the number of attractive investment opportunities diminishes, investors become increasingly eager to pour money into the market. It doesn’t make sense, but is the way things work. Buying stocks after prices have collapsed feels lonely, futile, and frightening to many investors, while joining a strong upward trend confers a sense of safety and validation. Human beings are social animals who feel more comfortable acting in concert with others than going it alone.

Following the crowd may work for a while, but eventually one has to break with the majority to be a successful investor. When the market is topping it is best to take a position contrary to the crowd. By limiting exposure to stocks early in 2008, we were in a position to make a major buy for clients after the steep decline of October 2008. At a time when other managers were bailing out to staunch the bleeding in their client accounts or mutual funds, we were in a position to pick up bargains. Proper positioning, well ahead of time, is essential if one wants to avoid the pressures that lead to bad decisions in the future. When caution is thrown to the wind, and everyone is diving back into the investment waters, we are inclined to head in the opposite direction.

Current Strategy

It is not surprising that the market finally rallied after falling by about 60 percent through 2008 and early 2009. With investors totally terrified, convinced they would never see another uptick in stock prices, the stage was set for a significant, relief rally. Investors were relieved that the worst case scenario of depression and financial system collapse did not materialize. The fundamental problem of too much debt in the system has not been altered by the relief rally in stocks. While individuals have reduced their debt balances somewhat, the government has offset that reduction by borrowing and spending trillions in an effort to salvage the economy. The overall debt level in the U.S. is an obstacle to future economic growth and to a continuation of the market rally.

 

Over the past few months the rally has evolved from one of relief to one of belief that things are getting substantially better economically. For the first time in eighteen months investors are feeling anxious about missing a big recovery in the economy and the market. Pressure is building to join the rally even if it means paying way up for most stocks. When fear of not being in the market starts driving investor behavior, we see a selling opportunity. Our strategy has always been one of taking gains after significant stock price appreciation, and this time is no different.

 

There are few options available for investors when it comes to very liquid, short-term, fixed income investments. The Federal Reserve continues to hold short-term interest rates at near zero on Treasury bills. The typical bank is paying somewhat less than one percent to investors willing to tie money up in a CD for a year or so. Even though short term paper yields next to nothing, bonds that come due further out are going up in yield. The ten-year Treasury note now yields 3.6 percent, up from 2.6 percent last spring. The problem is that longer term paper entails inflation risk. With the government borrowing and printing trillions of new dollars the risk of inflation has many people concerned. A yield of 3.6 percent will not look very good if inflation shoots higher several years from now. One alternative is foreign, sovereign bonds issued by countries that have stable economies and may be beneficiaries of natural resource inflation. We believe that Canada is one such country, and recently bought Canadian Government bonds for clients. We may make additional foreign bonds purchases in the future.

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