Negative Expectations at Their Highest in History

Our MarketPsych index of negative stock market expectations is now the highest we've ever seen (we've got data back to 1984).

The Fed's actions and words -- explicitly committing to bail out mortgage lenders -- should have lowered market negativity. Instead we got a morning rally afterwards and then further selling.

What we saw last week was everyone jumping ship - a real crowd effect. The only information driving investors was downwards price action and rumors of further collapses. The more stocks dropped, the more they sold. A positive feedback loop was created.

In psychology, a positive feedback loop is created when people base their opinion of how bad a situation is on the actions of others. When everyone is doing this, we can usually call it the peak of a mania or the bottom of a panic.

The market stopped being comforted by the Fed, which is a bit scary. Fortunately, it was primarily the financials getting hit today. The Biotech index was actually up 4%. A rally is certainly near (though I was wrong last week).

Eventually, when the supply of sellers decreases, because they've run out of shares or capital to sell, positive feedback loops can't sustain their negative price momentum.

The danger is that acting on negative expectations can become a self-fulfilling prophecy. I wrote about this in my book, with the example of Brazil's near debt default in 2002.

Essentially, the more investors avoid new bond offerings, and the higher rates go (especially for junk bonds), the more squeezed are companies that need to raise capital. Eventually many will go bust because they can't afford the high interest rates (which are high because investors are afraid the companies will default). If the rates had been lower (because investors were more calm), then the debt would have been service-able and the company would have survived. The crowd's pessimism really can make things worse (just as its optimism was problematic in allowing such overconfident risk taking through 2007).

At this point, it's important to ask "can it get worse?" (yes), "will it get worse?" (probably), and "has this been priced in?" (in many sectors, yes, much too much).

In financials it's not clear to me if it has been priced in, hmmm.... A rally in financials won't happen until we know where the next bogeyman is. And right now, there are lots of terrible rumors, but no new sources of pain. I think investors are waiting to see how the current pain will spread, since it's clear that the economy is slowing and the real economic slowdown hasn't been reflected in the numbers yet. "Who's next to collapse?" is often heard.

There are some amazing bargains out there. A stock or bond screen will demonstrate great values. I don't trust the numbers on financials (never have), but in some traditional industries low debt stocks with PEs of 6 and trading under their book values are much more common. I won't get specific because the blog is about psychology, not stocks picks at the moment.

But watch out for stocks vulnerable to the self-fulfilling prophecy of higher interest rates for "risky" bonds. That's whay I mentioned to look for "low debt" stocks.

Solutions to the current crisis include better political and regulatory management of the psychology of risk-taking, which isn't likely anytime soon (as I mentioned in my last blog post). It will take some deep understanding of human behavior in the Fed and SEC (and maybe an in-house psychologist or two) before we get such enlightened policy. In the meantme, there will always be bubbles and panics to take advantage of.

Historic times we're in. Now let's make the best of it!

Richard

CNBC INTERVIEW and Waiting 'till the Fat Lady Sings

NEWS FLASH: Marketpsych Managing Director Frank Murtha on CNBC today!!! See the video here.

Market fear is spreading, and that's a good thing.

This afternoon a stranger sitting next to me on the subway asked me how the market was doing today (someone who didn't know I work in finance). When anonymous strangers stop staring straight ahead, and start nervously inquiring after the health of the stock market, then it's about time to search for bargains. I figured that experience was the opposite of knowing it's time to sell when you shoeshine boy (or cab driver, or doorman) is offering you stock tips.

As predicted in my last blog post - shameless self-congratulation :) - the market would drop, bounce, and then drop again on greater fear. Below is this morning's market fear chart. Notice how investor pain has risen well above March's pain levels (this is a 7 month chart).

The sell-off will continue, in fits and starts, until the full depth of the (1) subprime mortgage defaults and (more importantly) (2) Credit (and thus liquidity) squeeze on borrowers is comprehended. As long as there is uncertainty, the markets will not rest, and the relief rallies will be only brief and tentative.

If the extent of overextended borrowers (and subsequent defaults) turns out to be as bad as the Chicken Little's are claiming (unlikely), then the market may not rally until congressional legislation is passed and it's ramifications are fully understood (not a good thing in the short-term). Such legislation would be intended to prevent further profligate borrowing by debt-weary consumers. And better credit monitoring and preparation for liquidity crunches (higher reserves) by financial institutions. As long as interest rates remain low, the expansion should continue with only minor economic consequences. It's just a waiting game now -- to see what the fallout will be, and then it will be time to buy.

Ah, but that's idle speculation of a nervous mind. We have had a pattern of profitable buying on dips recently (past 4+ years), and it's possible that many have become seduced by the ease with which they made money -- letting their guards down. That could end badly, or it could keep on. In any case, it will be safe to buy dips when the cards have all fallen and the hands are turned. We need capitulation, panic, and consequences. Then the liabilities of the losers will be known, and the mess can be cleaned up.

Happy Investing,
Richard

Psychology 101: Investor Panic! ... Time to Buy?

The U.S. stock markets have dropped 4% this week, and investors' fear levels are near the yearly highs set in March. Investor psychology is a funny thing -- but it's predictable -- and understanding it can make you a lot of money.

We've been mentioning in our blog posts over the past 2 months that as the stock market has gone higher, investors have grown more and more nervous. They have felt inclined to sell to "cut their winners short" just to lock in their gains so far. A brief market sell-off is exactly what drives investors to feel afraid when they've already made so much money.

Let me offer myself as an example. Every 6 months I create a 10 stock portfolio using a basic Yahoo! stock screener and a little due diligence (calling company CFOs, reading SEC filings, etc...). Takes me about 8 hours to complete the whole process, and the average return has easily been over 20% annually. Here are some of the older portfolios (which I stopped posting after 2005 due to time constraints). This January's portfolio is already up 25%. Which is obviously better than anticipated.

Frankly, that 25% 8-month return scares me. My account is 25% larger in only 8-months. Wow, it feels good. However, like almost everyone else, I want to take that money off the table so I don't lose it. I'm susceptible to cutting winners short. Why don't I? Because I know that my nervousness is not a trading plan, it's a road to underperformance.

Using our Marketpsych sentiment analysis tools, we've been watching the pain level rise over the past week. See this Marketwatch article (which mentions our Investor Pain Index) for a few details. The chart below was generated using our real-time proprietary sentiment software and it is plotted against the QQQQ (Nasdaq 100 ETF):
This chart shows the relative amount of pain measured among investors.

As you can probably see in the chart, the last time pain was so high was a great time to invest. So consider using stomach-churning pain as a Buy indicator. You don't need to "catch the falling knife," but you may want to enter buy stops slightly above the market, because any "relief rally' will be fast and furious.

Personally, I think the pain will probably spike again (and the market will sell-off), in a second wave, before a real buying opportunity presents itself (August and Spetember are yet to come). Consider investing some idle cash during an August sell-off, although also consider somewhere safer than the US dollar (e.g. Singapore or Malaysia) when those markets get hit.

Best wishes,
Richard