Expectations, the Stock Market, and The Prediction Addiction

Why is it so tempting to make stock market predictions?

Maybe it's an anxiety reliever -- predicting implies that there is a pattern, a cause, that can be found if only we look hard enough. Forecasting bolsters our sense of control.

At the same time, we all predict with similar neural "hardware." So maybe we all make predictions based on similar information, or at similar times? And if so, are we collectively usually wrong or right?

The answers to that question underlie our asset management service (MarketPsy Capital LLC).

The chart below displays negative expectations in the major business press (WSJ, Financial Times, Barrons, New York Times).



The chart shows Negative stock market expectations (the brown line) superimposed on a candlestick stock chart of the S&P 500 (SPY). As you can see in the chart, high negative expectations are not usually a good time to buy, until they fall.

Today negative expectations dropped when the Fed reported a willingness to lend to banks beyond September 2008.

However, creating a portfolio strategy out of the "buy on decreasing negativity" insight is not easy. For one thing, we can intellectualize and chart our pessimism, but we still believe it: "this time it's different, it really is THAT bad," we might tell ourselves.

And furthermore, somtimes negativity is justified, and the catastrophe really does happen.

Here is a chart of the same data series from a January blog post. Notice that we did get a stock market rally when the negativity decreased, but now it is higher than perviously.

The stock market is an anticipatory mechanism. It has priced in a lot of pain to come. The real question is, will the pain be worse than the market expects? If not, then it is likely to rally. And in general, people anticipate more pain than is actually experienced. They will even cause themselves greater pain in the present so they can stop anticipating future (smaller) pain. (This is called the cost of Dread). Many investors felt tempted to sell their stocks last week, just to save themselves the dread of further price declines.

This Fall we'll see if the credit crunch shows signs of abating. From what I hear and read (The Credit Crisis is Going to Get Worse), it will continue. And printing money (increasing liquidity) may not work as well in alleviating the squeeze this time.

That said -- and because I'm nervous about this market ;) -- I'd like to make a prediction. It's kind of a cheap sensationalist substitute for an educational blog post. Like the one that Frank just wrote. But here goes: I suspect we're due for another short-term rally. Expectations are vey pessimistic, and now they are becoming less so.

Those are my thoughts, but then, maybe I'm just seeing order in madness. On the contrary, given the statistical results of our research, I think we really have found predictive factors rooted in the collective psyche.

It was clever that Bernanke spoke about continuing debt relief today. Someday, I'm optimistic, the Fed will consciously direct fiscal, policy, and monetary factors to have a greater impact on the psychology of the economy's participants. This may help alleviate future bubbles and crashes.

But that may require a generational change, and I don't think we have enough evidence that it will not also do harm (though it can't be much worse than the enormous liquidity we've seen in the last decade). It's not easy to accurately model psychology or economic behavior, which keeps it out of the standard curriculum.

For now, we are seeing efforts to change fiscal policy that do have a positive effect on the psychology of consumers. Which is good. Someday those efforts will include specific language and will target more vulnerable psychological themes (housing insecurity, confidence to spend, fears of perpetual debt, etc...).

Richard

A Bull in the China Shop: The Fundamentals of the Worldwide Share Rally

We're in the midst of the biggest bull market in history. Virtually every asset class has been yielding double-digit percentage gains annually. Here in the United States, the boom is less obvious. In Asia, it is unmistakable and profound. Since this is a blog post, not a book on economic history, I'll try to keep my commentary on this world-changing transformation brief. In particular, we'll go back to the subject of China, which I think will be the defining story of the next century.

Pundits cite numerous reasons for the boom, the foremost of which is a liquidity glut. One explanation for the "easy money" says that as Asian and Middle Eastern nations receive US dollar payments for their trade with the United States, and they have enormous trade surpluses ($1 trillion in China's reserves so far), they are inclined to re-invest that money in dollar-denominated assets to avoid driving up the value of their own currencies. This buying pressure on T-bonds and T-bills leads to decreased interest rates and easier credit for business expansion worldwide.

The general idea is that lower interest rates make borrowing cheap. And who wouldn't borrow at 6% in order to invest in a business with a cashflow over 16%? That's a low-risk return of over 10% annually. Now multiply it times 4 using leverage (40% return), and you have a high-risk hedge fund or private equity fund at your finger-tips.

China alone is growing 10% per year. Many of its businesses are growing earnings 20-30% annually for the past 5 years, as evidenced in the China Stock Directory. Yet the Yuan is pretty stable versus the US dollar, so currency risk is low. Private equity funds can make a killing by arbitraging this type of interest rates to earnings differential. Makes sense that the Chinese government is a pre-IPO investor in Blackstone -- Blackstone gets preferred access to fast-growing Chinese companies, and China gets the know-how to set up a domestic private equity industry.

So there is a fundamental logic to the boom - that's my point anyway. But since this is an investor psychology blog, how can we know when bubbles form on top of booms? In particular, is China in a bubble? Some say that a PE of 42 for China Communications Bank is high, especially when HSBC has a PE of 13. Does a high PE alone mark the top of a bubble? Greenspan used the high PE = bubble logic when he insinuated the US market was irrationally exuberant in December 1996. His timing was way off, but it does have a historical logic.

In my studies of sentiment, tops are usually marked by high optimism. But so are the rallies on the way to the top. If you shorted every period of 2 standard deviations above average optimism over the last 20 years, you'd have zero returns. No matter how pessimistic you are, you have to admit that shorting optimism does not work without other objective criteria to go by.

In April, 5 million new stock brokerage accounts were opened in China. That is 2/3 more than were opened in all of 2006 (per the Economist magazine). That sounds like an investor frenzy. But guess what - they shoud be excited. China has been booming for 20 years, and the tipping point has finally been reached where domestic Chinese investors can chase hot stocks. It's healthy that people are getting involved. Does that mean they will emerge unscathed? No.

When will the psychology of the Chinese bubble become a problem? As I mentioned in a previous blog post, probably not until next year. So far the share prices have been rallying less than two years. While PE's are high in big name stocks, there are still some bargains in China(granted, many with murky accounting).

Even after last year's rally in the US (modest as it was), my stock screens found more cheap small-cap stocks this December than at any time in the past 3 years. And they are up 30+% since then. A rally does not prove a bubble, but it is necessary to one.

So the Asian economic boom is finally being followed by a real stock market boom (China and Vietnam in particular). This is good news, as it means their financial systems are globalizing. The selloff of May 2006 indicated that while some investors were skittish about the huge recent gains, the general trend remains extremely positive. This year is no different from 2006 in terms of economic growth in Asia, except that investors are finally catching on and assets are at or exceeding their fair values worldwide. Yet, they can certainly go further. There will be scary selloffs along the way (probably very steep), but they will be clearing the air for the next rally. Those are my thoughts at the moment. They may change at any time, as flexibility is the paramount virtue in the markets.

Next post we'll look at some recent neurofinance studies.

Richard

The Bugs Bunny/Road Runner Investing Hour!

Most of us remember growing up watching cartoons on Saturday morning.

I probably watched too much. It quite literally affected my ability to make sense of the world.

One of my favorites was The Bugs Bunny/Roadrunner Hour that featured the antics of a homicidal supra-genius named Wile E. Coyote who was obsessed with doing harm to a vocab-challenged Road Runner - the Moby Dick to his canine Ahab.

Of course, the coyote never succeeded. He got crushed, flattened and blown up every week. But he did teach us a fascinating lesson of cartoon physics that we can apply to markets -- particularly soaring ones.

In every episode, Wile E. Coyote would invariably pursue his elusive quarry off of a cliff. At this point, it became clear to the audience that the coyote was headed for a serious fall. And the more excitable among us were prone to yell things like, "Look out!" at the TV. The coyote; however, was blissfully unaware of his circumstances. In fact, breaking multiple laws of physics, Wile E. Coyote continued to churn his feet, levitating in the same spot, indefinitely free from all harm... until he did one thing; until he looked down.

Upon looking down, the impossibility (even absurdity) of his current status became clear. The coyote would gulp, usually produce a hastily assembled placard featuring the phrase, "Bye bye!" - and fall like an anvil into the void below.

Welcome to the world of investing bubbles. Welcome to Wile E. Coyote Sydrome (TM).

We've seen it before, throughout the late 90s when people were paying 200 P/Es for stocks based on metrics such as "eyeballs" ("eyeballs" is the new "earnings"!). The admonishments of the exasperated spectators (Julian Robertson & Dr. Robert Shiller come to mind), like those of countless children on Saturday morning, were there if you cared to listen -"Look out! You're going to fall!"

The Shanghai Composite has been running off the cliff for quite some time now. (I'm not saying you can't make money there. It's hitting new highs everyday, but if a market up over 200% in 2 years isn't a bubble... what is?) And the warnings coming from land are getting louder. But the coyote never listens. And he doesn't appear to hear Mandarin any better than English. He is far too engrossed in his pursuit to pay any mind anyway. But he'll look down at some point.

In the same way that the tragic coyote defies the laws of physics, investors defy the laws of economics, running on air as the market soars... 5%... 10%... 15%... I can't wait til next week!

But then the warning cries from the cliff break through to the investor's consciousness. And one looks down. (Sell). Then another. (Sell). Then another (Sell) and -- whoosh!-- (SELL! SELL! SELL!) -- the Panic, with its sickening plunge, is on.

And you don't need a sign that says, "Bye bye!" to know it.

Wile E. Coyote Syndrome (TM) at its finest.

So how do you approach this situation? Your wisdom (and high school physics) tells you to run back to land. But it's such a rush dancing off the ledge, and that's where the money is.

For one thing, do not underestimate human greed. Do not overestimate its reciprocal fear either. (Physics also teaches us that every action has an equal and opposite reaction, after all). Be prepared for both. Have cash available to pick the pieces off the ground. Anticipate the sectors to which people will flee. Run around on air for awhile, but take some profits too. Most of all, prepare yourself emotionally for the plunge, because its coming. And no one know when.

The great thing about ol' Wile E. is that when he gets smushed, flattened, and blown up, he bounces back good as new in the next clip.

Investors aren't so lucky. Raise your hand if you bought Intel at 90! (You can't see my hand, it's up.) In fact, many portfolios never bounce back.

So enjoy it while you can. Be prepared for the plunge. And you may want to consider shorting "ACME Gadgets Co." (Their rocket boosters have serious design flaws.)