Saturday, January 21, 2012

Where Are We Now on the Emotional Roller Coaster of Investing?

Periodically, I like to re-visit the Emotional Roller Coaster of Investing to think about where we are in the cycle. The chart below shows how different emotional states of investors change with the stock market. The green sections are normally bullish times to be invested whereas the red portions are bearish times.










Many studies have documented how individual investors, and even professionals, chase performance. When markets are doing well, investors get less concerned about risk and put their money to work in investments that have been doing well recently. Too often that means investing while looking through a rearview mirror. Unfortunately, that is often opposite of what we should be doing. This reality is confirmed by three of the most renowned investors of the past century:
- "The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell" -- John Templeton
- "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful" -- Warren Buffett
- "I have every confidence in the threefold merit of this general method based on (a) sound logic, (b) simplicity of application, and (c) an excellent supporting record. At bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public." -- Benjamin Graham

So, Where Are We Now on the Emotional Roller Coaster of Investing?
My own assessment is that we are now transitioning from 'hope' to 'relief'. To better understand the various stages, let's consider how investors' emotions have corresponded to our recent stock market history. The bull market 'euphoria' ended in October 2007 when the Dow peaked at slightly about 14,000. During the winter of 2007/2008, 'unease' began to set in as the Dow declined below its 200-day moving average. In the Spring of 2008 a decline in real estate values began to become apparent and investors transitioned to the 'denial' stage since it was so hard to believe that our long-held assumption of neverending increases in the value of real estate then appeared to be in jeopardy. 'Pessimism' ensued as the stock market continued its steady decline into the summer as the credit crunch became more apparent and the price of oil reached $150 per barrel. 'Panic' occurred in the autumn of 2008 with financial bailouts of some large banks; and culminated in the September bankruptcy of Lehman Brothers. The stock markets' steep decline continued through the winter of 2008/2009 with 'capitulation' occurring from late January to early March of 2009 when the market quickly declined by another 20%. Investors were clearly in 'despair' as the Dow reached its closing low of 6,547 on March 9th, 2009. It is said that "Hindsight is 20/20", but that low point turned out to be what John Templeton called "the time of maximum pessimism" and thus "the best time to buy".

During the 2 years and 10 months since that March 2009 low, the market has rebounded 94% to its current level of 12,720. During this period, the market has been climbing the proverbial "wall of worry". Investors have had 'hope' that the worst was over, but nevertheless continued to fear a return of the bear market. My current belief is that the strongly bullish stock market move during the last month is signaling the transition from 'hope' to 'relief'. As 4th quarter earnings continue to be released, it is becoming increasingly apparent that earnings are continuing to grow (albeit at a somewhat slower increase) and that the likelihood of a return to recession in 2012 is low.

If we are now entering the 'relief' stage, then the next question would be: What would enable us to move to the next stage of 'optimism'? My first caveat is that it is unrealistic to expect to accurately forecast future events. But my gut feeling is that we will continue in 'relief' throughout 2012. Europe will likely be in a mild recession. The U.S. GDP will likely grow at a relatively modest 2-3% while Emerging Markets growth will slow slightly, but their GDP will grow very nicely at about the 5% level. With the expected continuation of relatively low inflation, a worldwide GDP growth average of about 3% is supportive of an expectation of continued modest growth in stock prices in 2012 -- perhaps in the 8% to 12% range for the year. This viewpoint is also consistent with the Covered Calls Advisor's current Overall Market Meter rating of Slightly Bullish (see right sidebar).

The Presidential campaigns leading up to the election in November this year is likely to be more hostile than ever; and also a very closely contested one. The uncertainty surrounding the widely different viewpoints of the two candidates will tend to cause investors to be uncertain about the future and therefore cautious with their investments. Despite the 94% rebound, investors remain cautious and now continue to invest moreso in bonds than in stocks, despite the exceedingly low rates available from bonds. I don't expect investors' sentiment to change until after the election. In early 2013, as policy priorities and legislative changes become more apparent, it is possible that a transition from 'relief' to 'optimism' could occur. Of course, it is also possible that rather than advancing to 'optimism', 'relief' could jump directly to 'unease' (or some other place on the roller coaster). In the mean time, we remain in the green section of the emotional roller coaster -- where a slightly bullish investing posture seems most appropriate.

I hope this article is helpful in stimulating your own thinking about the current state of the market and also the importance of not allowing our emotions to have an adverse effect on our investment decision-making.

Do you agree or disagree that we have now entered the 'relief' stage? Why?

As always, I welcome your comments. Please click on the "comments" link below or email me at the address shown in the upper-right sidebar if you would prefer to keep your comments confidential.

Godspeed,
Jeff

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