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VIDEOPrimal Fears of a Double Dip Could Create Opportunities
By
James Kostohryz
Aug 27, 2010 7:45 am
People's innate tendency toward dichotomous thinking -- and its associated panic impulse -- could soon provide a chance to purchase stocks at extraordinary long term values.
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The exaggerated and inappropriate tendency for humans to expect extreme oscillations in their condition is an example of what some psychologists call cognitive dissonance. In the psychological milieu of financial markets this translates into a propensity for investors to think that if something isn’t going up, that it must necessarily go down (or vice versa). Another manifestation of the same sort of thinking is the notion that if the economy isn't getting better, it's getting worse (or vice versa).
However, it's a simple fact that at any given time it is far more likely that securities will move within a relatively confined range as opposed to spiking up or crashing down. And, it's far more likely that the general economic well-being will be maintained within a narrow range than there will be massive dislocations. The reason for this is that financial markets and a market economy are structures, products of a complex civilizational process, that promote stability. The very fact that we tend to think of financial markets in terms of instability is, in a way, another symptom of the cognitive dissonance that humans suffer from. The fact is that financial markets are a powerful stabilizing force in an advanced economic system.
With regards to the current situation, I believe that the pendulum of general psychology is ripe for a turn to deep pessimism about the economic future. During 2008-2009 folks became almost pathologically pessimistic about the future. In part, as a reaction to this overreaction, investors became open to the notion that maybe things wont be that bad after all. This has been the psychological foundation for the countertrend rally that occurred between March of 2009 and April of 2010.
However, beginning a few weeks ago, when the economic data in the US started to disappoint, the alarm bells started to go off in people’s head. As with a primeval caveman, folks feel like they're in the wilderness and vulnerable to a bear attack at any time.
A panic sequence may be triggered when folks start seeing and hearing the financial and economic equivalent of bear paws and/or bear growls. An attack may or may not occur, but the panic sequence (a survival mechanism) will be set off just the same.
If data continue to accumulate that the economic recovery is losing steam, fears of the dreaded “double dip” will become generalized. And given that a massive bailout operation won't be possible fiscally or politically (kind of like the situation of caveman in the wilderness), fears of an economic disaster will become widespread -- one without the benefits of analgesics.
At that point, the market will be in free fall -- perhaps testing or breaking below 950 on the S&P 500.
But if this happens, I suggest you ask one question: What happens if instead of collapsing, the economy simply stagnates? What if the economy settles into a scenario of slow growth and high unemployment?
Now let us ask the apparently analogous question that a caveman might ask: What if instead of charging, the bear simply minds its own business or even runs away? Herein lies the key to the cognitive dissonance I've referred to. The expected utilities derived from setting off a panic sequence in the wilderness when there are signs of wild bears in the vicinity and setting off a panic sequence with respect to your investment portfolio are vastly different. In the wild, if you take flight due to fear of bears, you lose virtually nothing. You might just become a bit winded. And over the long term, your panic response will increase your life span. However, in the context of modern society, if you sell all your stocks or start short-selling every time you feel panicky about the market going down, you'll surely end up in the poor house.
No positions in stocks mentioned.
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