Oh, Ye of Little Faith

Faith.

What is it? What does it mean to investors?

If something is provable, certain... there is no need for it.

You don't need faith when you already know.

Faith is for the times when you really don't know.

It's the belief in something despite a lack of evidence.

The essence of faith is doubt.

We investors are getting our faith tested these days.

Faith in policies that we were assured will fix the problems. Faith in the people who make them. Faith in companies who say their balance sheets really are okay. Faith that investing in stocks is a good and safe choice for the long term.

Algonquin Round Table raconteur, Alexander Woollcott once said, "Everything I love is either illegal, immoral or fattening."

Exactly.

Cheating vs. Owning Up?

Looking the Other Way vs. Taking a Stand?

Broccoli vs. Red Velvet Cupcakes?

You want a short and reliable guide to making the "right" choice?

It's the one that's most difficult to choose.

So here we have a market that is tantalizingly cheap (historically speaking) and absolutely terrifying.

What choice do you make if you have a long term horizon?

I say unto thee, brothers and sisters: Those who have faith in this market will be rewarded somewhere down the road.

I believe that. In fact, I'm acting on it.

But to tell you the truth, I'm just going on faith.

Investors Are in the 4th Stage of Grief - Depression

It's been a depressing time to be an investor these past few weeks. In my opinion we're at the worst point in this crisis so far, yet surprisingly to me, the MarketPsych Fear Index has only begun to rise in the past 3 days.

I think investors have been in a state of despair, not fear. They have essentially become resigned to further losses. That's obviously not healthy for the markets. And on a technical level, it doesn't bode well for a price recovery. On a psychological level, I think the entire financial community is in the 4th stage of the Five Stages of Grief called "Depression." See midway through this blog post for a prior discussion of the five stages.

The image above was borrowed from Irvine Housing Blog, and even though it incorrectly orders the progression of the Five Stages, it gets the point across.

I've been to New York to train portfolio managers and financial advisors every month since the crisis began, and I'm finding a tragic progression in the psychology of the people I've spoken to, just like the stages of grief (above).

In late September, I still heard hope - "this is a bad year, but it might still recover." A few people were frazzled and had abandoned their long term strategies for cash, but the vast majority had stayed invested and were taking big losses. (In general, the hope for a recovery, and the attempts to time the bottom, are characteristic of a continuing price slide, not a bottom.)

By late October I encountered paralysis and shock. There was furious scribbling when I described stress management techniques, but otherwise the portfolio managers I spoke with were somewhat listless and exhausted.

Last week, I encountered profound sadness, hopelessness, and despair. Some people approached me with deep concerns about their abilities to keep their jobs and their clients.

Nothing will ever be the same on Wall Street, and I'm afraid the shakeout of the financial industry is just beginning.

By being real about where you are, and staying positive and proactive, you'll make it through this crisis OK. Remember to work on the things you can control, and let go of those you can't. And dust off your Plans B and C - hopefully you won't need it, but knowing it is there is psychologically settling.

Once you've come to terms with the sad realities we're in, then it's time to start positioning for the future. There are great opportunities that come out of every crisis, and there is usually plenty of time to spot them and take advantage, since so many others are paralyzed. For example, boat trailer sales are up, since many people can't afford marina slip fees for their boats anymore. And of course, Safe sales are up... There is always opportunity, but sometimes it requires a little more creativity to see it.

Best wishes,
Richard

Et Tu Lehman? The Contagion of Fear

There are many events, and more importantly RUMORS of events, putting the market on edge.

There has been a surge in the MarketPsych Fear Index, in part due to Lehman's potential implosion, this time due to excessive and illiquid leveraged positions. With Lehman's request for $6 billion to fill in the hole dug by CMOs and excess borrowing, the market is back on the brink.

All this in the context of early summer. Recall from a prior blog post that there is truth in the saying "Sell in May and Go Away" - here is a great graph of the effect.

The specter of world oil and commodity price shock, inflation, flooding in U.S. agricultural regions and drought in Australia's, war with Iran, and general purpose catastrophe has reared it's head again. I don't mean to be glib. There is danger afoot. This isn't one of those merry "buy on the pullbacks" type of markets. Or is it?

There is indeed a developed world deleveraging happening. Will that spread to the developing world? It appears to be anticipated in recent stock market performance, but then, that may have been developed world money fleeing those markets, which is my opinion. And that doesn't mean the sky is falling.

The "sucker's rally" Frank and I predicted in March has come and gone. The DJIA passed 13,000 and then dropped back again. So here we are again, down 8% for the year.

So it's not looking good for anything except commodities and oil? No, that's not what I'm saying. I'm fairly interested in technology, pipe (yes, steel tubes for drilling), recycling, shipping, land, and many mining stocks. India and China aren't slowing their growth much, even though the US is, and they use lots of raw materials still. One land and oil trust that I've held for years, and plan to hold for many more is Texas Pacific Land (TPL), and also a pipe company, WEBC. Yes I own shares in these, and if you try to buy WEBC, you'll move the market, so please don't.

But wait, I need a legal DISCLAIMER here of some sort. Hmmmm..... (nervously scratching my head)... OK, so don't buy TPL or WEBC. I'm not recommending them. I'm just saying they're out there. I don't want to get sued because someone bought one now and sold it when it fell or went bankrupt and they lost money. Like I said, "DON'T BUY TPL OR WEBC!!!!!" Please don't, really.

I think I'm covered now. Whew!

And here's what's interesting: when investors are primed to be cautious because of one bad event, they often extrapolate that danger into other spheres (in my case, fear of litigation). When in fact they might want to find inflation-hedged stocks, which will continue to perform over time. But this is very difficult to do when you're afraid, because of neural "priming" in the anterior insula of the brain.

A fascinating study which we profiled here, by neurofinance geniuses Brian Knutson and Camelia Kuhnen, demonstrated that activation in the brain's anterior insula predicted excessive risk avoidance in an investing task.

Building on this finding, Greg Larkin, Brian Knutson, and collaborators found that anterior insula activation appears beneficial for learning which dangers to avoid. See their paper here. A light summary in Psychology Today is here. Interestingly, people who are more constitutionally "neurotic" (nervous) have more insula activation when faced with monetary losses. While being "neurotic" isn't usually seen as a personal positive (especially by neurotic people, who are already predisposed to worry that something isn't right anyway), it turns out that neurotic people (with their greater reactivity of the insula), are better at learning to avoid financial losses going forward. Insula activation did not affect learning to pursue or avoid financial gains. So I didn't do the study justice here, but hopefully more on its implications later.

While perma-bulls buy on the dips, more anxious investors may be rightly on the sidelines, waiting for these storms to pass. And their sitting out the volatility has now been proven right a few times over the past 12 months. Yet, then they might get stuck sitting and never acting. The market is always a balancing act.

In our in-house research, it's not the absolute level of market fear that predicts a market rally, but a retreat from a high level to a lower one. That's what you'll want to look for before buying. And for the past 12 months we've had historically high levels of fear.

What causes such retreats from peaks to lower levels? It's usually a resolution of some dangerous anticipated event. For example, the collapse of Bear Stearns and the Fed's willingness to step up and put a floor under the CMO market. That resolved a tremendous amount of uncertainty.

If Lehman can raise $6 billion, at a not horrible price, then I think another level of uncertainty will be resolved.

If the Iranian government stops declaring they plan to wipe Israel off the map (fat chance!), then there's another level resolved.

So it looks like the fear will continue for a while..., but we'll still hae some ups and downs that present good buying oppotunities in select sectors.

Happy Investing!

Richard

Nice Call, Master Yoda

Market: I'm not afraid!

Rich: You will be.... you. will. be.

Regarding your previous post, you may not have to be worried about the absence of fear for long.

The MarketPsych Fear Index has seen an uptick recently.

One reason I believe it has meandered of late is that a critical and catalyitc component was missing: The appearance of a nightmare scenario that the individual can; 1) experience viscerally, and 2) consider credible.

The Bear Stearns news today presented just such a scenario, and it sent a shockwave of fear through the markets.

We simply do not live in a world where "Modest CPI Numbers" can compete with "Wall Street Institution Imploding Overnight" in a market-moving contest.

If it sets off a "fear cascade" (think dominoes), we may just see Market Panic make it's first reappearance in years.

Getting my cash ready now...

Rising Fear, China, and Applied Behavioral Finance

The MarketPsych Fear Index is rising (it was already fairly high before today's selloff). Apparently there was a considerable amount of nervousness before the market opened today, and that nervousness escalated into outright fear by day's end. Maybe a front-page (C1) WSJ article about buying on dips sowed doubt in investors today. "When Crash Means Buy" - brings out the Chicken Little in me.

BUYING ON DIPS

There was no useful info in the WSJ article (such as when to buy on dips and when not to), except that it sowed doubt about what has seemed a surefire strategy. Essentially, since buying on the dips has worked so well for so long (definitely since 1987, excepting the 2 1/2 years for tech stocks after 2000), many investors have become used to increasing their position sizes every time there is a downturn in shares. The article is a little ominous, and certainly hit the market at an already nervous time.

SIVs are the newest "What the...?" to come to the attention of the market. And uncertainty is almost always a negative, especially when the cause is interminably murky and needs $100 billion bailout packages organized by the largest global banks. Once the damage of SIVs comes to light, then the market can rally again, but for now it doesn't look good that another hidden risk has emerged to damage the financial sector.

CHINA A-SHARES

If you've been a regular visitor to our website since it opened - which is doubtful :), then you've known that I've always been bullish on China, and even set up an Investing in China webpage in 2004 to facilitate research. As I mentioned last month, the market is topping now (though may have a little more juice until February, after which it's best to steer clear). Appears that Hong Kong H-shares are doing spectacularly as an arbitrage play. Also via the WSJ (fine journal, that).

As long as Hong Kong remains in anticipation of local Chinese monetary inflows (and as long as it hasn't started arriving), then that market (especially H-shares) will have upside pressure. Ironically, Chinese investors are having tremendous difficulty opening accounts in the one city where outflows to the Hong Kong markets will be permitted (Tianjin Binhai New Area), and the pilot program was ultimately postponed, so no Chinese cash has made it to Hong Kong legally yet. But that is the genius of the Chinese authorities. By announcing the impending program, the premium of A-shares over H-shares has started to dissipate. And if history is any guide (as when the Chinese gov't announced in late Feb 2001 that the B-share markets would open to local investors in June 2001), then the actual financial inflows from China will probably mark a medium-term top in both markets.

WHAT'S THE USE OF BEHAVIORAL FINANCE?

What's the use of behavioral finance? That's the motivating philosophy behind a wonderful organization in Los Angeles -- the Behavioral Finance Working group of the CFA society. Here's their discussion group online.

I was fortunate to give a talk to the group yesterday. I met some great people and got lots of new ideas about how to apply behavioral finance to several areas:
1. Defeating you own investing biases.
2. Helping advisory clients to understand and avoid making biased decisions.
3. Finding opportunities in the markets.
More about those in upcoming posts...

Happy Investing,
Richard