The Investor Psychology Cycle
As the pendulum swings between greed and fear, investors typically behave in 1 of 2 ways: They either become over-enthusiastic during bull markets and over-despondent as the bear’s growl grows louder.
It stands to reason that in order to be a successful investor, it's important to distance yourself from the herd mentality and to take objective decisions based on fundamental reasons.
The typical behaviour of investors is linked to the so-called investor psychology cycle (courtesy RMB Unit Trusts), as illustrated below.
Before seeking to apply the cycle to the present stock market situation, let’s consider a short definition of each of the stages.
- Contempt: According to the cycle, a bull market typically starts when a market is at a low and investors scorn stocks.
- Doubt and suspicion: They try to decide whether what they have left should be invested in a safe haven, such as a money market fund. They've burnt their fingers on stocks, and vow never to invest again.
- Caution: The market then gradually starts showing signs of recovery. Most remain cautious, but prudent investors are already drooling at the possibility of profit.
- Confidence: As stock prices rise, investors’ feeling of mistrust changes to confidence and ultimately to enthusiasm. Most investors start buying stocks at this stage.
- Enthusiasm: During the enthusiasm stage, prudent investors are already starting to take profits and get out of the stock market, because they realize that the bull market is coming to an end.
- Greed and conviction: Investors’ enthusiasm is followed by greed - often accompanied by numerous IPOs on the stock market.
- Indifference: Investors look beyond unsustainably high price-earnings ratios.
- Dismissal: As the market declines, investors show a lack or interest that quickly turns to dismissal.
- Denial: They then reach the denial stage, where they regularly affirm their belief that the market definitely cannot fall any further.
- Fear, panic and contempt: Concern starts to take hold; fear, panic and despair soon follow. Investors again start scorning the market. Once again, they vow never to invest in stocks again.
In order to determine where in the stock market cycle we find ourselves, the challenge is to identify the prevalent stage of the psychological cycle.
I would, for starters, argue that we are on the right-hand side of the curve - but how far down we find ourselves on that slippery slope is less clear. It would seem that we're possibly in the region of the denial/ fear/ panic phases.
Although enduring investor panic and fear haven't really set in, the January, March and July sell-offs did witness climatic -- albeit short-lived -- bouts of despair.
Time will tell whether we're dealing with a typical investor psychology cycle, and how it will play itself out. It does, however, seem that we are at not at the “contempt” stage yet, i.e. when investors scorn shares en masse and a bull market typically starts.
I do believe we are still in a primary bear market where stock markets are, at best, faced with a prolonged convalescence period characterized by sub-optimal returns. Whether significant further declines take place from these levels -- and whether valuations will overshoot to bargain levels, triggering bouts of panic and fear -- is anybody’s guess.
However, in the short term, I give the nascent stock market rallies the benefit of the doubt, provided the mid-July lows are sustained. For any rally to become more enduring, further base building will be necessary -- possibly wearing investors out to the point of contempt -- and an eventual shift in central bank policy to targeting GDP growth rather than inflation.
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Maybe I'm spending too much time listening to the talking heads on CNBC, FBN and Bloomberg. Those guys are still trying to "find the bottom" which to me means they're in denial.
When one begins to think that there might never be a bottom, that's the begining of the "fear, panic and contempt" phase.
We have a long way to go. As Mr. P would say, "risk is high."
Today, he looks prescient....but he remains severely depressed. In fact, he and many others I know have definitely entered the "contempt" phase, including my wife.
Now, I rarely go through any of these cycles. I think psychology impacting a view on what you do in the market is dangerous. That doesn't mean you don't have these feelings. But how you manage them and analyze them is key.
Overall, I'd say I passed denial in August last year, assuming what I had could be termed denial. Since then, it's been utter indifference as I realized how I felt mattered little. I doubt I'll ever change that view again.
Where are we in the cycle? Depends on who you're reading. The pundits, depending on who they are, are going to be gleeful in a regular way. Things are always good when you're looking for investors.
Journalists, however, love doom and gloom. It always sells. When's the last time you saw a headline that said "Sunny days, clear skies and lots of good times ahead"? Invariably, the BEST headline will read "Dow goes up record amount" or something to that effect, followed up by details about how the gains are tenuous, at best.
But horrid facts are wonderful to writers, so they focus on them.
Amateurs, I'd say, entered contempt phase quite a while ago. My wife was screaming to pull out her 401(k) money last November and I told her to relax and let things happen. Sure, so far she's beating me with a stick, but we'll see....
Regardless of what happens, I'd say the amateurs are usually the LAST to reach the contempt phase. So the real question is this - how long will the contempt last?
If you go back to the 1910's, or the 1970's, the last two similar markets to this one, it was purely a professional's market. This market is moving in a manner that suggests it's primarily driven by the pros. Does that mean their views matter more? I don't think so, UNLESS the individual amateurs never come back (which is unlikely). Eventually, they will. Then things get interesting again.
Just my two cents. I'm no pro. I just play one on TV.
Targeting inflation?! Since when have they been targeting inflation? They are already targeting growth, trying to prevent it from being recognized for the negative number it is. You can't call negative real interest rates a policy of targeting inflation unless you mean by this they are trying to promote inflation. Screw the stock market. They will be lucky to salvage the bond market.
In terms of market behavior, which is the best way of gauging sentiment, seems to me what we are seeing is a lot of bottom picking. That kind of behavior is characteristic of an early or midpoint in a bear market, making for lots of quick rallies and quick declines. So, I suppose I agree with Prieur that the phase is "denial".
I have to admit that I am also influenced in my view by the impression that the extent of the market decline seems understated compared with the unbelievably dire news we have had since November, 2007. So, that proves I am just another biased observer.
