The Psychology Behind Market Meltdowns

Summary

• Panic is precursor to market meltdown.
• Psychology is an important determinant of bear markets.
• It won't be over until 'acceptance' takes over sentiment.

We need panic! It's the first step towards recovery - but not the last. A true market meltdown, if this is one, starts with panic - and we're not there yet. The following is a direct quote from my A Maverick Investor's Guidebook:

Here is just a small sampling of the great financial panics since the turn of the twentieth century:

• Stock Market Crash of 1929 (aka the Great Crash)
• The 1973–75 recession
• The recent financial crisis of October 2007 to November 2008

A market panic occurs in a few steps:

• Stock markets fall rapidly and unexpectedly. This is because there is suddenly far more sellers of securities than there are buyers. News travels fast. Markets are actually an information industry.
• As stock prices decline (as well as the prices of other assets such as bonds, real estate, and commodities such as oil or copper), all sorts of investors begin to panic and try to sell their stocks and any other assets deemed to be vulnerable—and this all happens at the same time. Anyone who might have been interested in buying assets is spooked by the landslide of selling and postpones any action.
• Once the dust settles, volumes on stock exchanges and other markets dry up. Sellers realize they can’t sell if there are no buyers. Potential buyers are worried that anything they buy will devalue even more. Checkmate.

Photo by: Daniel Naupold/Reuters

What's been missing until recently is real panic. There are too many pundits in the press and on television telling everyone not to panic, and that once the novel coronavirus is under control things will be back to normal. This presumes that it is only the virus that is the problem. As I've mentioned in previous articles, excessive liquidity caused outrageous valuations, and the actual global slowdown are the issues - sparked by COVID-19. When optimism hasn't yet been crushed, there's room for several 'dead-cat' bounces. Another anecdotal example that investors are in denial is the insistence that stocks are on sale and it's the perfect time to average down or step in.

I write occasionally for financial sites and comments like these are typical:

Why should I avoid Exxon Mobil when the price is $47.69? The yield is 7%. And the average analyst price target 52 weeks from now is $70.50.

or:

One of the government-appointed Chinese researchers working to control the outbreak told the state-run newspaper People’s Daily on Thursday that, based on the data, he expected Wuhan to hit zero new infections later this month.

My answer (calmly) to the first is because you're already losing money offsetting the dividend, and to the second: Who relies on news from China?

Different than a correction, a meltdown requires the market (i.e. the sum total of all investors' psychology) to transition through the 7 stages of grief:

Dr. Kübler-Ross refined her model to include seven stages of loss. The seven stages of loss model is a more in-depth analysis of the components of the grief process. These seven stages include shock, denial, anger, bargaining, depression, testing, and acceptance. Kubler-Ross added the two steps as an extension of the grief cycle. In the shock phase, you feel paralyzed and emotionless. In the testing stage, you try to find realistic solutions for coping with the loss and rebuilding your life.

The stock market is still in denial (having already suffered the shock phase), Once equity investors begin to get angry, they'll soon begin to really panic and move to irrationally (bargaining) blaming all sorts of things (their investment advisers, consultants) for their misfortune. Then depression must be endured before making adjustments (testing) to their portfolios, with an eye to the future rather than denying the past. When markets have accepted that things are simply different, then a new rally with new leadership can get underway.

There are other models of grief, but most present similar stages (whether 4 or 6 of them). What makes for a prolonged bear market is when investors (they're just people) at large get stuck in a stage.

So when is the optimal time to throw money back into the market? There's not nearly as much press coverage of daily gyrations - it's no longer 'news.' Analysts are no longer revising down their earnings estimates and target prices. At the very bottom, reported earnings are rising faster than analysts are willing to make upward revisions. In fact, many analysts have been let go as their firms looked for ways to cut costs (as an aside, the most promising sectors at this juncture are the ones that have no analysts left on the payroll). Economically sensitive sectors (industrials, mining, consumer products and services etc.) are typically the first to skyrocket while nobody is paying attention.

Photo by Markus Spiske on Unsplash

So, as the photo suggests: I want lots investors to panic. It will confirm we're in an actual meltdown rather than 'just' a correction. I won't panic, but will calmly assess the market's progress through the grief cycle and wait for that opportunity to jump in - just as I did in 2011 when I wrote the book. Here's another quote from my book:

If your bets aren’t working, stop betting.

The best thing to do when confused and making bad decisions is to stop and do some thinking. Be rational, not emotional.

Data by YCharts

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[wald22]

Debt should not be considered an asset. The value of debt needs to be written down. Same was true in 1929 and it is true today. Over the next 5 years everything will be reduced in value.

[Malvin Spooner]

It happens when borrowers default. Will be plenty in oil patch.

[wald22]

The bottom line is that we've had severe flu's before without a recession and when we did have a downturn, the economy bounced back. Presently the stock market is pricing in a steep drop in profits, which is a very sure thing because those profits never existed in the first place. Using debt as a vehicle to buy back shares to increase earnings per share is not the same as earning those profits from profits made earning them. US corporations have a lot of money invested in China that is now dead money.

[jbbson]

To the first: why buy when Im already a losing? would you initiate a new position, based on fundamentals at the new price?

"to the second: Who relies on news from China?" everybody that panicked

[Malvin Spooner]

I would initiate when the ‘experts’ STOP SAYING THIS IS TRANSITORY. When they capitulate then it’s time.