Friday, August 5, 2011

A Word of Advice About the Markets

Everybody is preoccupied with yesterday’s market debacle, so allow me a few comments.

I am not going to offer words of wisdom about the markets, but about emotion. Specifically, about the way savvy market participants use emotion as a guide to action.

On Wall Street the conventional wisdom says that you should act contrary to the prevailing market sentiment. If everyone is optimistic, you should sell. If everyone is pessimistic you should buy.

Extremes of emotion tell the savvy investor to run against the crowd.

Of course, if everyone is following this rule, then the appearance of too much pessimism will turn a lot of people too optimistic too soon.

It’s much easier to state this rule than to follow it.

Inevitably, after a major market wipeout, sage commentators man the media battlements and advise everyone to stay calm.

Don’t panic, Dave Kansas wrote this morning in the Wall Street Journal. When everyone is afraid, you need to keep your head and act rationally. Kansas concludes that the economic situation is not as bad as a lot of people think it is, so you should look for bargains.

In his words: “So, as the markets crater around you, keep a cool head and look for opportunities that make sense. As Warren Buffett says: ‘Be fearful when others are greedy, and be greedy when others are fearful.’ No shortage of fear out there on Thursday.”

As always, this is not as easy as it looks. Kansas, a wise man, uses fear and panic interchangeably, as though they are the same thing. As it happens they are not.

But, how can you tell the difference?

Baron Rothschild once said that you should buy when there’s blood in the streets. Was there blood in the streets yesterday?

The image of blood in the streets is more vivid than a spike in the VIX. The latter index measures market fear.

Before even trying to get an accurate read of market sentiment, let’s acknowledge that there are times when fear is the rational response. It may be that the people who were selling stocks yesterday were acting rationally. It may also be that the people who are holding on to their stocks because they hope that things will turn around are being irrational.

Fear is not the same thing as panic. If you are walking down a dark street and start to feel fear, you are probably reacting to an unperceived danger. If your fear does not become panic you will take immediate precautions to reduce the danger.

If you panic you will not be able to address the danger. You might freeze; you might run screaming into the arms of a predator who was stalking you.

Panic makes people act irrationally. Fear can coexist with reason.

As for measuring the fear or panic of market participants, we need to keep in mind that there are not very many individual investors in the market these days. The stock market long since become the playground of large institutional investors and hedge funds.

Better yet, a goodly part of the trading is run by computer programs that, dare I say, feel neither fear nor panic nor greed.

Worse yet is the effect of over-leveraging. How much of what appeared to be panic selling represented forced selling by people who were receiving receive margin calls? How much of the sell-off was panic and how much of it was deleveraging performed by computerized trading programs?

In a market panic, everyone sells everything, indiscriminately. In a bout of deleveraging they do the same thing.

Also, consider this. In today’s America, and not just in America, large segments of our population have chosen to regulate their emotions with medication.

Thanks to SSRIs,  Americans have been drugged into an irrational optimism.

When you are reading today’s reactions to yesterday’s market collapse, are you reading optimistic reports about what can be done to fix things or are you reading pessimistic reports about why we can never fix things.

Only the latter would show true panic.

If you are optimistic, how much of your emotion reflects your assessment of economic reality and how much of it has been biochemically enhanced?

Today, people are talking about how the Federal Reserve is going to come riding to the rescue with another bout of quantitative easing, and about how we can solve our problems by spending more money that we don’t have.

In a market panic, everyone tells you to run for cover. Today, people like Dave Kansas are telling you to look for bargains.

In a market panic, people swear never again to buy any stock ever again. When people are not in panic mode they are looking to buy the dips.
For what’s it worth, people who are afraid are probably right to be afraid. As long as we have not abandoned all hope, we have probably not yet reached panic mode.


The Ghost said...

"Better yet, a goodly part of the trading is run by computer programs that, dare I say, feel neither fear nor panic nor greed."

you would be surprised at how many of these programs are setup ... in many ways they are programmed to behave in ways that would look like panic if a person did it ... also don't forget that often institutional investors have initiated the underlying order that the programs is implementing and their orders may very well be based on fear or panic ...

many (if not most) institutional orders are executed thru the use of algorithmic trading programs designed to allow the orders to be executed at the best average price over the entire day ... the problem is these "algos" are designed based on averages like daily trading volume and such ... on a day like yesterday we did not have an average day so some of these programs would have had difficulty managing their orders as cleanly as they would have during a more normal day.

You are correct to say that the program doesn't "panic" but the program also doesn't realize when others are panicking either and will do trades that a human would back off from since they realize their counterparties are panicking.
In those cases a person would normally back off and allow them to continue to panic and drive the price up or down to higher or lower levels .

In the end the market goes down becasue there are more sellers than buyers at the higher prices ... the programs really don't change that ...

Stuart Schneiderman said...

Thank you for clarifying this point.