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Tuesday, February 21, 2017

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 rear view 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?
It is certainly more of an art than a science, but my own assessment is that we are now in the 'exhiliration' stage. 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 subsequent almost 8 years since that March 2009 low, the Dow has rebounded 217% to its current all-time high level above 20,700. 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 recent strongly bullish stock market move is signaling the transition from 'enthusiam' to 'exhiliration'. 

If we are now in the 'exhiliration' stage, then the next question would be: What would enable us to move to the next stage of 'euphoria', thus signaling a likely market top? My first caveat is that it is unrealistic to expect to accurately forecast future events, but the single most likely event that could propel the market even higher and into the 'euphoria' stage would be passage this year of a tax reform bill similar to that currently being developed by Congress that would include a reduction in the corporate tax rate from its current 35% level to somewhere in the 20% to 25% range -- a change that would certainly be a substantial benefit to future corporate earnings prospects for many companies currently paying above 30% in Federal taxes.

On the other hand, it is also possible that rather than advancing to the 'euphoria' stage, we could jump directly to 'unease'.  This would most likely occur with continuing Congressional gridlock that results from an inability to obtain approval on a bill that would achieve the proposed reductions in the current corporate and individual tax rates.  This 'unease' would signal an end of this 8-year long bull market.  The current uncertainty and concern that we might be near a market top is also reflected in the Covered Calls Advisor's current Overall Market Meter rating of Slightly Bearish (see right sidebar) as detailed in the most recent post on this topic here: link.  Given the current uncertainty in this regard, a prudent investing stance favors the current recommendation of the Covered Calls Advisor's Overall Market Meter, namely to establish slightly in-the-money Covered Calls (at strike prices below the current stock price).

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 are now most likely in the 'exhiliration' stage? Why?

As always, I welcome your comments. Please email me at the address shown in the upper-right sidebar.