Visualizing Market Fear

How can you cope with market fear? Many investors consider this a crucial question. Yet it often isn't until periods of fear and sharp market downturns that investors think, "now I know I shouldn't sell everything, but it really hurts!" It's at these times that the excellent investors and traders stand out. They can muster the courage to buy in such markets, even as the financial news and media pundits are screaming, "The sky is falling!"


The MarketPsych Fear Index was displayed on the Wall Street Journal's C1 Money and Investing page a couple weeks ago (Tuesday, September 11, 2007) See article here. See left for the unsmoothed Index used in the article.

The MarketPsych Fear Index helps investors visualize the fear they are feeling that is affecting their judgment. Studies show that we're all affected by market fear, and it takes a lot of courage and experience to step back and see the fear and identify the opportunities that it creates. The first step is understanding that fear is contagious. The second step is identifying where it is and how strong it is. That's what our Index allows.

Now for a brief bit of self-congratulation. During his three CNBC appearances in August, Dr. Murtha rightly re-assured long-term investors that August was a good time to hold stocks, think long term, and consider buying where opportunities could be found. One of my blog posts called the bottom of the sell-off and predicted the rally to come.

Given the intensity of the recent fear, we're on track to continue a bullish Autumn for US equities. Malaysia (MAY) also looking good with deep discount to earnings (PE of 2) and declining dollar protection.

Interesting action (potentially near-term topping) in China. Tremendous profits made in Chinese shares so far the last couple years. Average PE is around 60 now (notwithstanding some accounting shenanigans, such as not counting state-owned shares towards market caps). More on China in another post.

Richard

Like the Kids Say... OMG,TMI!

There's and old expression; "A little bit of knowledge is a dangerous thing".

I'd like to add a corollary; "and so is a lot".

I was curious to see what the Market would do on Monday (June 4, 2007), because of the two events that occured on the weekend: 1) The Shanghai Composite dropped 8.3% and, 2) A terrorist plot to blow up JFK airport (and much of Queens) was nipped in the bud.

Truth be told, I was hoping for a nice big drop so I could go bargain hunting. But it was not to be. Perhaps because enough people shared my reactions; 1) The Shanghai Composite is a small and not terribly significant market that is nearly 70% comprised of small Chinese citizen investors - it shouldn't matter that much to us; 2) Oh, terrorists are hatching plans to blow up New York? Really? Tell me something I don't know.

And The Market shrugged. (Damnit)

So it didn't create the buying opportunity, I'd hope for. What it did do was call to mind our strange and paradoxical relationship with financial information; that we want more of it... and that getting it usually hurts our financial decisions.

Knowing too much hurts a lot of our decisions. In his book, Blink, Malcolm Gladwell details how Cook County Hospital simplified their ER triage. Their model eliminated all but four pieces of data to determine whether to admit a patient for a heart attack (electrocardiographic evidence, presence of unstable angina, fluid in the lungs, and a cutoff point for systolic blood pressure). Any additional data - even data that look relevant such as weight, age, etc. -- and the decisions got worse. To borrow an expression from teen-speak, it's "TMI" (Too Much Information.)

No one has understood or exploited the human mind's unhealthy relationship with TMI better than the Gambling Industry.

Ever been a horse track? The helpful track owners provide information on lap times, finishes in previous races, breeding, performance in mud, or rain, on grass, on dirt, the record of the jockeys... they give you literally 100s of different variables to factor into your decision. Does it help? No! It's TMI. Many data points are simply red herrings. But the relationships between the variables are too complex, and the sample sizes usually too small, to make any meaningful conclusions anyway.

The gambling industry knows that most gambling information is specious; it looks important, but is useless for prediction. Sometimes they even know that we know. At a roulette table, the board above the wheel posts the last 20 or so numbers that came up. Nothing could be more irrelevant, and only the most naive player doesn't understand this. But people actually pay attention to what happened before! They love it! "Oh, look. It hasn't hit # 23 in a while!", or "It's been black 4 times in a row now!" Seeking TMI isn't just a human inclination, it's fun!

So what of investing? With Blackberries, Real Time Market Quotes... Jim Cramer, we have more information than we know what to do with. And it's available any time. How do we sift through the haystack of data to find the needles or relevancy?

It starts with an understanding that much of the information we encounter is like that on the roulette board - interesting, but irrelevant. It also means recognizing that, even with quality information, you can have too much of a good thing. Lastly, we can recognize that information that is Frequent, Emotional Evocative in content, and Recent are most likely to be overly influencial in The Market's short term decision-making. (I would say that the terrorist plot meets the last two criteria and the Shanghai drop meets all three). It's a great way to spot short term buying and selling opportunities.

Simplify. Avoid TMI.

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.)