Investor Psychology and Market Expectations

A Guide to Help You and Your Clients Weigh the Risk vs. Reward in Today’s Market

Investors are facing the most difficult environment in decades. Although we know there is no ointment that can cure investors during this difficult period, we wanted to share our perspective on the current market.

"The word 'crisis' in Chinese is composed of two characters: the first, the symbol of danger; the second, opportunity."
- Anonymous

• The stock market has seen its share of turmoil this year.
  
• Since 1950, the S&P500 has had 152 days where the index was up or down by more than 3% (1% of 14,820 trading days).
  
• Since Sept. 2008, the S&P500 has had 32 days where the index was up or down by more than 3% (52.5% of 61 trading days).
  
• Out of the 32 days, 20 have been down more than 3%, 12 have been up more than3%

Value Investing

Value investors believe that markets over react to negative news…

• “Buy when there’s blood in the streets” - Baron Rothschild in 1871
• Benjamin Graham and David Dodd in their classic book, Security Analysis, asserted that over reaction was the basis for a value investing style.
• “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." - Warren Buffet

Behavioral Finance

• Prospect Theory: Investors value gains and losses differently (Kahneman and Tversky 1979).
• Cognitive Bias (Winner Loser Effect): De Bondt and Thaler (1985) argued that investors overreact to both bad news and good news. Therefore, overreaction leads past losers to become underpriced and past winners to become overpriced." De Bondt and Thaler propose a strategy of buying recent losers and selling recent winners. Investors become too pessimistic about past losers and overly optimistic about past winners.
• Representativeness Heuristic: Barberis, Shlieifer and Vishny (1998) argued that investors find patterns in data too readily, tend to over react to information and conservatism (clings to prior beliefs, under reacts to information).

Then & Now

As of November 14th 2008:

• The Median Company in the S&P500 has -2.5% Sales Growth priced in for each of the next 5 years.
  
• The Average Company in the S&P500 has -5.0% Sales Growth priced in for each of the next 5 years.
  

This assumes a 5 Year Median EBITDA & Asset Turnover for each individual company in the S&P500 (monthly).

Because investors value gains and losses differently, markets tend to overreact. This creates extraordinary opportunities.

Overlay: VE Analysis and Market Psychology

Equity Mutual Fund Flow

Chart Source: Investment Company Institute and Trim Tabs

“Don't try to buy at the bottom and sell at the top. It can't be done except by liars.”
—Bernard Baruch

Hedge Fund Selling Pressures

The tremendous growth in hedge funds over the past several years has made it more difficult for managers to earn high returns.

“The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences."
—Richard Bookstaber, A Demon of our own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (Wiley 2007)

The SEC ban on short selling (9/19/08 to 10/8/08) caused more pressures on hedge fund selling because managers could not implement long/short positions like they could in past.

High Water Mark: The assurance that a fund only takes fees on profits unique to an individual investment: "If all they get is the management fee, why work?" observes Tom Taulli, an author and investment banker with Instream Partners in San Francisco. "What's the motivation?“

“Renowned New York hedge-fund honcho and political powerbroker Richard Perry is facing down his first losing year in hedge-fund investing since launching his fund some 20 years ago.” NY Post 10/16/08.

Timing the Market is Hard

Market timing: Market timing is the practice of many investors to try to predict the best time to buy and sell stocks based on expected market direction. For example, an investment manager might switch a portion of his holdings from stocks into cash when he believes that the market has peaked.

If he times the market correctly, he could make a huge profit. Then, when he thinks the stock market is significantly undervalued, he could shift back into stocks in an effort to make another hefty gain. If such an investor was able to successfully time the market since 1950 until today and avoided the 20 worst performing months for the period, he would outperform an invested-at-all-times strategy by 465 basis points annually. As shown in the chart below, the payoff on such a strategy is very significant.

On the other hand, timing the market incorrectly has significant negative consequences. An investor that missed the 20 best months over that period, underperformed by 335 basis points a year.

Market timing has many potential pitfalls, and if you're trying to wait out current volatile conditions in order to maximize the value of your stock portfolio, you are taking on a huge risk for a strategy that is nearly impossible to accomplish consistently in the long term.

This Time is Different*

How The Last 3 Months Compare to the Worst 10 Months on Record in S&P500 since 1950

Every Bull Market Starts with a Bear Market

CNBC Profits From Investors’ Anxiety, Fear, Greed, and Optimism

Source: Wikipedia.

There is a fairly clear long-term correlation between the performance of global stock markets and the audience ratings of CNBC. The network had a difficult time attracting viewers in the first half of the decade, but has seen viewership increase from a 2005 bottom to record highs in 2008, coinciding with the subprime mortgage crisis. CNBC continues to possess the wealthiest audience (in terms of average income) of any television channel in the United States.

Note 1 : Hempel, Jessi (31 March 2008). "CNBC Feels Your Pain...", Fortune. Retrieved on 31 March 2008.

What Other Investors are Saying….

Good Advice

“This is a once-in-a-lifetime opportunity. It's even better than the '70s. Certain common stocks are being given away. It is absolutely a time to plunge in. .”

– Marty Whitman, Third Avenue Management, October 14, 2008
S&P500 Index = 998

“Buy American. I am…A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.”

– Warren E. Buffett, Berkshire Hathaway, October 16, 2008
S&P500 Index = 946

“It’s the single best time in my career that I’ve seen to invest. There is more value out there than you could ever imagine . The spread between price and value is the widest in many years, 30 or more years. Price are way below value.”

– Bill Ackman, Pershing Square Capital Management, November 13, 2008
S&P500 Index = 911

Japan Valuation Quintiles

(Percent to Target Current – Ranked by ALL)
Jan 1990 – March 2007

We believe that the Japanese Market (1990 – 2007) was the closest resemblance to the current US Credit Crisis. This table shows how valuation worked with the Japanese Large Caps (top 50% of Market Cap) from 1990 to 2007. Since 1990, an investor that indexed in Japan suffered negative returns. However, investors that used valuation were rewarded with an annualized return of 6.0%.

Conclusion

• 2008 has been a very emotional year for investors. Emotions (and redemptions) have caused the markets to sell off to irrational levels. This has created a tremendous opportunity for long-term investors.
• Timing the market is a loser’s game and nearly impossible to achieve consistently.
• Even if we are not at a ‘bottom’, we know that investors will earn superior returns from current market levels.
• Our experience in Japan tells us that valuation works in ‘bad markets’.

For further insights on investment opportunities, we recently calculated the implied sales growth rates for all the industrial/service firms in the S&P 500. Read our "Then and Now" study and download a list of stocks that may have been overly punished. Click Here to Read and Download.

Final Thought:

“Remember, my son, that any man who is a bear on the future of this country will go broke.”
–John Pierpont Morgan, December 10, 1908

Comments

[BobTrader:]

I think the key is that we have not reached capitulation. Hard to do anything but short this market till there is real feeling despondency. This wild volatility to me indicates we have not reached that point.

www.freetradingquiz.co.../

2008 Dec 02 11:21 AM

[Kayboe:]

This is one of the best summations of the current markets I have read in Seeking Alpha or for that matter in any publication.

Further conclusions I got from this piece:
1. Stop watching financial television.
2. Don't trade this market unless you're already a trading pro. (You'll be killed!)
3. Hold your nose and buy quality value in small, medium and large caps on significant down days, (of which there are plenty). Try to average in.
4. Don't panic sell -no matter what happens.
5. Review your portfolio less than you do now.

2008 Dec 02 11:42 AM

[vinodsharma007:]

Human Mind and its thought and its underlying psychology along with the inherent nature that man is born with, are directlyy linked to higher dimensions called the God.
Just like the economy, the markets are not controlled by humans although our ego thinks we do. Otherwise,there will not be any depressions as occurred in 1929 and every one will become millionaire.

2008 Dec 02 12:16 PM

[Pat Shuff:]

ftalphaville.ft.com/bl.../

en.wikipedia.org/wiki/...)

2008 Dec 02 12:22 PM