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Resisting Market-Psychology Extremes


In volatile times, don't forget to think for yourself.

On my last appearance on Kudlow & Co, I expressed serious concern about the level of enthusiasm for the markets, particularly for the Goldilocks economy. The Great Moderation anchored the economic nirvana supporting ever-higher equity prices.

Then the credit crisis erupted, and the rest is all-too-well-known.

Led by predictions of oil at $200 a barrel, commodity prices soared in the summer of 2008. Then came the second wave of the credit crisis, and, with it, fears of a global slowdown and demand destruction.

When we flash-forward to today's environment, we see the same characteristics we saw just months ago, only in reverse.

Greed and fear are 2 sides of the same coin, though they may manifest in different ways (greed typically exhausts itself over a longer time period, whereas fear tends to be shorter, more panicky, more urgent.) However, they share one common characteristic: Each is characterized by certainty. And with that certainty comes predictions of where the current trend will take us. Predictions of higher highs or lower lows become the norm.

For those investors willing to take the longer view, every market episode teaches us something. Sometimes the lessons are profitable; however, the most valuable ones are painful and expensive.

One of these lessons is to never get too caught up in the extremes of market psychology. Market psychology is like a rubber band that can stretch beyond normal bounds. Statisticians and strategists refer to standard deviations from the norm.

John Maynard Keynes said it all too well: "Markets can remain irrational longer than you can remain solvent."

The bottom line is simply this: Don't make the same mistake twice. Don't accept the depression era and deflation talk unchallenged. If you believe this is where the global economy is headed, fine. If not, that's fine as well.

But in all cases, exploitation of the conditions at hand should be your modus operandi. And in that regard, it's good to remember this: Investors who dominate today's markets may be called professionals, but they're still human, and they're still subject to the same behavioral factors that affect everyone else.

As I've stated many times before, they are more loss-averse than risk-averse. They will also act in a herd-like fashion far more often than they will act in a rational, dispassionate, long-term and contrarian way. For current proof, all you have to do is look at the 3-month US Treasury yielding under-the-mattress level returns.

Be it irrational exuberance or panic, market psychology is always taken to extremes. And during those extreme periods, voices of perspective are drowned out by the cacophony of trend predictions.

Bye, bye Goldilocks. Hello, Bride of Frankenstein.
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