It would be nice if predicting stock prices were based on an accurate measure of economic data, but it does not work this way!

stock market cartoon

Market psychology is an important element of stock and bond prices. Psychology in turn is highly dependent on the news to which investors are exposed especially coupled to their biases of recent market history. This means that if the past 2yrs-3yrs of investment experience have been positive, then we tend to pay more attention to positive news events. The psychological term is called “The Recency Effect”. Likewise, if the most recent 2yrs-3yrs of investment experience have produced negative surprises, then we give greater weight to negative news events and almost ignore any information of a positive nature. Some have described this as part of a deeply ingrained, i.e. genetically coded, human survival mechanism which has protected us from dangerous situations for millions of years.

The same ingrained survival mechanism which alerted us to avoid lions and tigers by paying attention to warnings from our peers and typical visual signs of danger operates identically in the investment markets and causes most to fear potential losses. The problem with this type of response in the investment markets is that the average investor acts with the crowd behavior which has been shown over the years to be detrimental to one’s long term investment success. The best investors are contrarians not followers!

The best means of developing a contrarian investment strategy comes from historical study of market drivers. Market psychology is a significant short term market driver, but it is virtually always based on what the crowd thinks and feels as if “Market Sentiment” is fundamental to investment success. Value Investors know that markets over the longer term actually are controlled by fundamentals of economic activity. It is economic activity which once a trend has been in place for 2yrs-3yrs then becomes reflected in general market psychology. So, in the final analysis it is economic fundamentals which eventually drive the large swings in market psychology, but it is “The Recency Effect” which shades current events with the past few years of experience. The Value Investor is always looking forward not backward.

We find ourselves today 3 1/2yrs from the market lows of early 2009. Even though there has been news which could have caused the markets to swoon in May-Aug period, we have not. The “Bad News” has not found a hand-hold while the “Good News” has gradually been finding a larger audience. This is reflected in the daily 10yr Treasury Yield chart below. As investors begin to sell bonds to invest in stocks rates begin to rise! Suddenly, Retail Sales are higher, US Exports are higher, oil prices not deemed to be a headwind and Europe is deemed closer to finding solutions with its debt issues than was thought just 4mos ago. Yes, there is still “Bad News” being reported. In fact Bill Gross of PIMCO issued his “The cult of equity is dying” report and Harry Dent issued his DOW forecast of 3,000 the past few weeks, but they have received little media attention beyond the first few days.

Calling a turn in market psychology is a very difficult thing to do. I do not invest based on trying to identify and invest with or against specifically the many sentiment inflections which sweep the market annually, but I do pay attention to them. Poor market sentiment makes for lower prices and better opportunity and vice versa. Today, we have experienced a recent stretch in which investors have shaken off negative news and embraced the positive news. Being 3 ½yrs from the market lows of early 2009, the timing is right for investors to begin factoring in the nearly 100% gains since the March 2009 SP500 March 2009 low of 667 as part of their current investment thinking.

We, however, have been investing with the fundamentals and have been very positive since early 2009. If the psychological turn is occurring as it appears from pessimism to optimism, it is welcome. Fundamentals suggest we still have 4yrs-5yrs left in this economic cycle. Even predicting economic fundamentals is difficult but is easier than predicting market psychology. Market psychology sets securities prices. If the economic activity is strong and long enough, the sentiment will be more positive and the equity markets ($SPY) will be higher. Only time will tell how high the markets can go and when! For now, it appears that psychology is improving.

In summary:

It appears that market sentiment is turning more positive and more in line with economic fundamentals. I will keep monitoring the fundamentals.

It is about time!

10yr 624x396 Market Psychology Now Seems To Be Acknowledging Fundamentals