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Stock market

31 Oct 2013

Moving along the investor psychology cycle

Stephen Silcock | Portfolio Manager

In order to determine where in the stock market cycle we find ourselves, the challenge is to identify the prevalent stage of the psychological cycle.

The Nobel Prize often recognises the contribution and achievements of recipients long after the first publication of their ideas. However, this year’s Economics Prize is interesting in highlighting seemingly contradictory results of research on asset allocation. The award this year went to Eugene Fama, Robert Shiller, and Lars Hansen – with the apparent conflict between the work of Fama and Shiller providing interesting (and heated) boardroom discussions over the last few months. Shiller’s central assertion is that animal spirits – greed and fear, to you and me – drive financial markets and make bubbles a frequent feature (this is at odds with the views of Fama – who formulated the efficient market hypothesis that states that all publicly available information is reflected in stock prices already). 

 

Shiller’s work demonstrated that markets make errors, and his insight, that psychology plays a key role in setting prices, was very much out of the mainstream when he began enunciating it two or three bubbles ago. Shiller’s assertion on animal spirits has prompted an esteemed colleague, Jeremy Baxter, to relook at a chart that encapsulates his position. This chart, which shows the investor psychology cycle, has been hanging on the office wall since early 2009. We like to call it “The Baxter Bulge”, and incidentally it has nothing to do with an expanding waistline. In any event, where we are in this cycle has been keenly debated over the last couple of years.

investor psychology
Stephen Silcock , Wealth & Investment

Shiller’s work demonstrated that markets make errors, and his insight, that psychology plays a key role in setting prices, was very much out of the mainstream when he began enunciating it two or three bubbles ago.

Stages in the cycle


Before trying to say where we are at the moment in the cycle, let’s go through the definitions of each of the stages.

 

The Baxter Bulge
  • Contempt: A wholesale aversion to equities as an asset class. This stage usually marks the beginning of a bull market, and the best time to start buying shares.
  • Doubt and suspicion: This stage is characterised by anxiety, with markets (often fuelled by the media and other commentators) skeptical about the likelihood of recovery.
  • Caution: The market starts showing signs of recovery. While most investors remain cautious, forward looking investment managers grow more bullish as the potential for data to surprise on the upside.
  • Confidence: Caution gives way to a new found confidence as share prices move upwards. It’s normally at this stage that most investors start buying shares.
  • Enthusiasm: All stocks go up on a rising tide. Trustees usually start trying to move money into equities as they continue to outperform all other asset classes. Contrarian investors may well take profits at this stage.
  • Greed and conviction: Greed rules. Everyone is talking about the stock market. New listings abound. Euphoria permeates. Taxi drivers are mortgaging their houses to buy shares.
  • Indifference: Warnings that shares have become expensive are largely ignored.
  • Dismissal: “It’s different this time,” or “It’s just a healthy, short term correction before resuming its upward trend,” are heard on the fairways and in the corridors as markets start to decline.
  • Denial: There is a communal opinion, after some heavy falls, that the market is about to turn around. “It surely can’t fall any further”.Fear, panic and contempt: Concern gives way to depression, panic, capitulation and desperation.
In order to determine where in the stock market cycle we find ourselves, the challenge is to identify the prevalent stage of the psychological cycle.

Interestingly, this week, this particular coastal branch where my esteemed colleague is based decided that markets had moved from the Enthusiasm phase, (where markets have been for over a year), into the beginning of the Greed and Conviction space.

Will they be proved right? We wait and see …Perhaps when our hairdressers start telling us which shares they have started buying, the dial will move towards indifference…..

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