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Market Psychology
Contrarian Basics
If I were to cite the single most important idea behind contrary opinion it would be that, at
any given point in time, an investor’s emotion is much more likely to be functioning to hold
him in a given position than it is to impel him to perform an action in the future.
Given some
time to consider this, I think most people would have to admit it makes a good deal of sense.
Doesn’t it stand to reason that an investor who is very bullish on stocks would already have
invested his money in them?
Certainly if he is extremely bullish on stocks it would tend to
indicate he has thought about them, and probably suggests he has opened a brokerage account,
or at least allocated some of his retirement account to stocks. Otherwise why would he have
such a strong opinion on the matter? Indeed, many investor surveys are drawn precisely from
a pool of avowed, practicing investors. Why would a practicing investor be sitting on the
sidelines cheering the market upward without placing a bet?
Similarly, if a person is
tremendously bearish on stocks, it only makes sense that he would already have sold them.
Given these basic concepts it follows quite logically that bullish extremes are associated
with market tops. If the investment surveys show that people are extremely bullish, it
suggests they have already invested and are waiting for the market to conform to their
expectations. And, logically enough, if they have already invested their money, that means
the price action has already occurred in response to that demand. The equal and opposite
arguments can be applied to market bottoms.
Perhaps the best way for someone new to the idea of contrary opinion to get behind it is to
think of opinions as inhabiting a range, rather than existing on a chart without limit. This
could be thought of as a scale from 1 to 10, or the distance between two goal posts, or the
limits of an elastic band. Obviously it is difficult to quantify an emotion, but it seems
reasonable that there is an extreme beyond which an investor simply cannot become any more
bullish. Whereas a stock price (especially an exciting technology stock with a great story)
can go upward seemingly forever, this is not so true of emotions. Euphoria is euphoria, fear
is fear.
Limits to intense emotional states
Even if we grant that there is always some level of emotional intensity that could
conceivably top the current state, we must also admit that it becomes increasingly exhausting
to maintain that intensity, and therefore ever more likely that the emotion must eventually
subside and return closer to the median range. Further, even if there are greater emotional
extremes possible at any given time, there are practical limits beyond which increased
intensity will cease to have an effect. For example consider the person who has taken every
last available dollar, borrowed on margin and even taken a third mortgage on the house to
buy stocks. Does it really matter how much more bullish he becomes? He’s tapped out anyway.
Likewise, even if the skeptics claim that there is always a greater level of fear than what
exists at any given time, they would have to concede that there will eventually come a time when
further bearishness isn’t going to make any difference. If a person has already sold all of his
stocks and converted all holdings to gold and short term T-bills, does it really matter if he
believes that the Dow is going to plunge an extra 300 points?
Obviously, it is not always so simple as this. In the real world there really are people who
sit on the sidelines for years watching the market going up, fully believing that it will
continue to do so, but just find the whole idea of buying stocks too far outside their realm.
So they do nothing for a long time. Only when neighbors start an investment club, or family
members introduce them to a broker, or they respond to an offer in a magazine to learn day-trading,
do they actually begin to invest money.
Persistent trends
Markets exist in a social environment, and often work
against considerable resistance in both directions. This is why sentiment indicators can hold
for a long time at apparent extremes of a given emotion and still keep trending. In a long
downtrend this means the market is working against excessive hopefulness and trust in stocks.
In a long uptrend it means the market is working through accumulated distrust, apathy and anxiety.
In the most recent bull market, which spanned 1982 and 2000, it took considerably longer for the
market to fully tap all of the resistance than many analysts realized at the time. Even some of the
most savvy investors believed that the end was imminent as early as 1995. At this point, excepting
some temporary pullbacks (most notably the sudden plunge of 1987), the market had enjoyed an uptrend
for thirteen years. In itself this presented a good case for an imminent reversal merely on the basis
of its duration. But there were also good reasons from the standpoint of contrarian opinion. To
cite some examples: the Indata institutional equity Cash to Assets Ratio had plunged from a high
of 17.9 in 1982 to an extreme low of 3.2 in early 1995, suggesting that institutional investors had
attained an extreme of complacency. Likewise, one well known survey of the percentage of US
households holding stock had shot to a high of 37%, the highest figure ever recorded at the time.
The previous record had been set in September 1987 right before the crash. There were more: The
tremendous growth of mutual funds, for instance, and the very low ratio of cash to stocks and
bonds, all of which were pushing at the outer limits of bullishness. Yet, as history revealed,
the market still had five years to go before topping. Few could have foreseen that the market
would keep heading up for another five years, pushing sentiment to extremes of euphoria never
seen before.
This is one reason why it isn’t exactly correct to “always bet against the crowd”, as the saying
goes, even though there is a strong element of truth to the idea. A much better way of putting it
is this: “Follow the crowd once it makes a new move and cash out before they realize they went too
far.” This is important because the market can travel a long way under the spell of bullish or
bearish sentiment without reversing. Simply because the market is registering an extreme of
sentiment, does not mean it will turn the next day or week. What is absolutely true is that the
higher the level of bullishness, the more fuel there is for a decline once it begins.
A long heat wave...
When there are
millions of fresh investors who have scraped together money to buy stocks and are anxiously
anticipating an advance, it’s a bit like having a forest full of dying trees and then suffering a
long heat wave. No one can say for sure what will touch off the fires, or where exactly they will
start. But fires will begin, and they will burn everything in sight, even trees that were young and
relatively healthy. The ever rising faith and euphoria which accompanied the rise in stocks serves
as fuel which will eventually drive prices downward, which is precisely what the insiders and market
timers are looking for. Similarly, once the market has bottomed out and the public has become
completely disgusted with stocks, it is a bit like surveying a field of burned stumps and ashes.
Hard to imagine new life springing from the ruins, yet the fire has produced a surprisingly rich
soil which will stimulate new growth well beyond the imagining of most observers.
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