Emotion and Valuation

 |  Includes: IUSV, IWV, SPY
by: Todd Feldman

In a paper written for the Journal of Investing, I study the various behavioral biases that have the largest negative effect on investor performance. Some of these biases include overconfidence, selling winners too early and keeping losers too long etc. The one bias that I find to contribute to the worst performance by far relative to other biases is recency. Recency is the tendency to rely too heavily on current information in making predictions about the future. For example, if prices are going down today investors believe the worst is yet to come. If prices are rising investors believe they will continue to rise. Right now the media and investors are forecasting doom and gloom after the most recent two weeks.

At Behavioral Finance Investment Advisors, we believe the recency effect is to partly blame for the latest market correction. Investors believe that the problems in the U.S. and Europe will lead to another 2008 type financial crisis. Investors are unclear how the banks in Europe and U.S. are exposed to the sovereign debt in Europe. This creates uncertainty and a belief we can relive 2008. This may be true. However, according to our work regarding behavioral finance and cycles, the U.S. and Europe are not in a financial crisis cycle. If a financial crisis is to occur we believe it will occur between 2012 and 2014 with a greater probability of occurring in 2014 as it will take time for interest rates and inflation to increase.

If we take a look at one of our behavioral measures it becomes evident that a market correction was needed. We employ an agent-based behavioral model to estimate the total leverage used in the U.S. stock market. The idea is that if our measure is close to 1.00 the market is fairly valued. However, if it is lower than 1.00 the market participants are holding cash and therefore the market is below fundamental value. And if the value is above 1.00 market participants are using leverage and therefore the market is trading above fundamental value. The estimate of the total market leverage is based on using data of market participant positions and returns. This is the agent-based part. We manipulate individual fund data first before aggregation. The figure below shows a chart of our leverage estimate since 2001.

Figure 1: U.S. Leverage Measure

Results indicate that the U.S. stock market became overvalued in May as the leverage indicator rose above 1.00 for the first time since 2007. This was a quick resurgence. After the tech crash in 2002 it took four years for our leverage indicator to again increase above 1.00. In comparison this time around it took two and half years. Of course we need to account for the technological differences that allow for quick trading. Even so, the increase was too fast in our belief. Therefore, a market correction was necessary to decrease the stock market below 1.00. Currently, the leverage indicator is at 0.92. Because of the lag in this indicator it is probably lower such as 0.88. We will have to run it again next week. Either way the U.S. stock market leverage is a good amount below 1.00.

Therefore, what do we recommend? Of course the U.S. stock market can go lower and we could see similar volatility. However, our indicators indicate that this correction was needed and we are now set to go higher before the next major downturn. Therefore we recommend to slowly buy into U.S. ETFs such as SPY, IWW, IWV. If you are concerned about the U.S. invest in Asia such as China, Thailand, or Indonesia. Also, commodity market places such as South Africa and Brazil are starting to look more attractive.

Disclosure: I am long THD, EIDO.