Point of view: Fear and loathing in the markets
Investor fear and greed have always been major market motivators. With greater knowledge and availability of information, will it always be so? Are they likely to become more, or less, of an influence in future markets?
Some market characteristics change all the time. For example, the way the equity market reached recent record highs was almost leisurely compared with most previous bull markets. There wasn’t the frenetic stock seeking that we usually see — for example, the daily price rises and trading volumes experienced in the recent ‘tech boom’.
Yet the apparent steadiness during September and October still hid a great deal of daily volatility in individual stocks, and some counter-intuitive price movements following many company announcements.
Some company share prices rose on what seemed poor profit results, others fell on what appeared to be positive company news.
But almost certainly we’ll see boom and bust cycles continue.
The psychology of markets was well documented as long ago as 1841 by Charles MacKay in his book Extraordinary Popular Delusions and The Madness of Crowds.
An extract from the preface to the second edition in 1852 says: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
MacKay’s recount of popular delusions were based on ‘bubbles’ over the centuries leading up to the 19th century, and we have experienced even more recent periods of madness, as in the last tech boom.
This is the greed or envy of markets, to create unsustainable over-valuations, eventually to burst with severe consequences.
It’s been going on for a very long time and there is no doubt we will see the phenomenon again.
Such market booms and busts may never be quite the same as the last one, but there are an awful lot of similarities.
These days, efficient markets require that all known information is built into share prices on a rational basis. This requires all participants to behave in a rational manner. Experience and observation tells us this doesn’t always happen. Market participants are human and all the weaknesses that affect daily lives must also affect investment decision-making.
In fact, it is not hard to see the seven deadly sins at work: pride in not accepting a wrong decision; greed in wanting higher capital gains; envy at others achieving rewards out of a bull market; anger at not recovering bad positions; power (lust) in building empires; avarice in over-extending/borrowing to achieve excess riches; and sloth in not being diligent and letting bad positions deteriorate further.
When added to the pursuit of the ‘free lunch’ syndrome — reward without risk — the fear of being embarrassed by failure, plus the emotional attachment to favourite stocks, it is little wonder that mispricing of stocks and markets occurs.
This mispricing can present an opportunity to a disciplined investor.
The art and science for a value investor is to recognise under-pricing when it occurs and be cautious that a ‘value-trap’ has not occurred. This is that shares in the company are not under-priced but in fact correctly priced.
Value traps also occur when there is a fundamental industry re-rating or valuation shift that needs to be recognised.
The events that under-price a stock due to market sentiment (for example, fear) are not confined to ‘value’ style companies. They can equally apply to those ‘growth’ style companies that include a premium for growth potential still believed to be attainable — for example, where adverse media comment causes the price to fall below its intrinsic value.
It is why knowledge about the company is important — not just recent knowledge that suggests a company is a good buy, or a must sell.
It is knowledge accumulated over a period of time, against which the present circumstances can be evaluated and decisions about the intrinsic value of a company can be made.
It is this searching for intrinsic value that will overcome fear and greed as motivators.
Or put more correctly, it is recognising intrinsic value that allows sensible investors to take advantage of those driven by fear or greed.
Michael Good is chief executive of Tyndall Investment Management .
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