Nary Quite Contrary... 2009

"It is easy in the world to live after the world's opinion; it is easy in solitude to live after our own; but the great man is he who in the midst of the crowd keeps with perfect sweetness the independence of solitude." ~ Ralph Waldo Emerson

Before I begin with the portfolio structure portion of my Where to Invest 2009 series of posts, I thought it fitting to discuss a non-quantitative, non-scientific perspective of investing -- market sentiment.

I can't help but think we are almost at the complete opposite position we were two years ago -- a time when the "easy forecast" for a new year (2007) by media pundits, economists and most financial bloggers was for higher stock prices; market sentiment (feelings and emotions of investors and financial market participants) was blindly optimistic; and an unfolding of (and end to) a healthy bull market and easy credit environment was difficult, if not impossible, to see...

For today's post, I would like to take you back to January 2007, when I wrote a post titled, "Nary Quite Contrary."  Here are a few poignant points from that post two years ago:

After pouring over all of the forecasts for 2007, I do not recall seeing a single one that is negative on the economy, its outlook or the direction for stocks. 

...but I do believe that the current overwhelming optimism over the direction for stocks sends the signal that the end of this Bull Market is closer than many of the talking heads will openly say.

 As of November 2006, Margin debt was around $270 billion, which is just short of the record set in the year, 2000.  Think along the same lines as your neighbor who moved in two years ago and used a three-year "interest only" adjustable rate mortgage to buy more house than he can afford.  It's the kind of risk that may not be financially sustainable and it typically points to troubled times lurking around the corner, especially when that kind of hungry speculation becomes wide-spread.

I believe that smart investors should not be afraid to take strategic 'baby steps' away from the crowd, given the right signals, even if they appear to look 'foolish' at the time.

If market sentiment was extremely positive two years ago, and we know what soon followed that blind optimism, could we not apply that same logic on the opposite end of the emotional spectrum today?  Or could it be that my persistent reliance on logic has an equal potential to be blinding as well?

A post on market sentiment would not be complete without a graphic illustration.  Let's take a look at this graph and ask a few more questions to finish our observations today (click on the graph for a larger image, if needed):

 

In hindsight, I would characterize the unfolding of the credit crisis in August 2007 as Anxiety; and the resumption of bullish behavior to a record on the Dow in October 2007 as Denial, which largely extended, but slowly diminished, into September 2008, when real Fear dominated market sentiment.  I believe Desperation and Panic followed in October 2008, extending to November 2008...

Where do you think we are in the market sentiment cycle now?  Personally I believe we are somewhere between Despondency and Hope, which is why I also believe we are also at or near the Point of Maximum Financial Opportunity.  Of course, market sentiment can fluctuate and it can remain at Despondency and Depression for a long-period of time before Hope gives way to Relief and Optimism. 

"It's important to choose not who you think is the prettiest girl, but who the judges will think is the prettiest girl." ~ John Maynard Keynes

The "judges" are the investor herd and it is not prudent to wager against it.  To expand on my usage of contrarian thinking, however, I believe that the investor herd, or "the crowd," is "right" most of the time... but not all of the time.  The few points at which the crowd is "wrong" are marked by extreme emotion, which I would more specifically define as "blind optimism" or "blind pessimism."

The media also perpetuates this blindness (and helps a contrarian observe the crowd's market sentiment) by choosing the sensational headlines, rather than those of rational perspective. For example the big headline last week was "Most Jobs Lost in 34 Years." This headline is accurate only by the number of job losses, but when measured by percentage, it ranks at a modest 41st in historical rank.

Some contrarians point to the magazine cover indicator, which highlights the media's sensationalized reflection of mass sentiment of the moment, coming from information in the immediate past (remember stock price movement is based upon future expectations -- not past).  The image in the right margin is a 1929 New Yorker magazine cover (hat tip to The Big Picture).  We all know what followed soon after...

"We must not, therefore, wonder whether we really perceive a world, we must instead say:  the world is what we perceive... To seek the essence of perception is to declare that perception is, not presumed true, but defined as access to truth." ~ Maurice Merleau-Ponty

I have observed that the four most dangerous words for an investor are "it's different this time."

Certainly, the economy has broad weakness with several pockets of extreme weakness that will persist for months and, in some cases, for years or even a generation; however, my logical conclusion with respect to market sentiment is that things are not as bad as most perceive them to be and perhaps a bit worse than a very small minority perceive them to be.

As an investor, and as an investment adviser, I will not wager that we are headed for a depressionary environment or Japan-like scenario just as I will not wager that we are at the bottom of a V-shaped stock market cycle.  I'll expand on how I will "wager" with investments in the next "Where to Invest 2009" post...

"What the caterpillar calls the end of the world, the master calls a butterfly." ~ Richard Bach

Finally, when I honestly review my inner thoughts, feelings and perspective, I will admit that I am a person who simply chooses to see the silver lining surrounding the darkest of clouds; however, I am also a logical and curious thinker, which has served me well as an investor and a money manager.  As such, my only likeness to the investor herd is that I have been "right" most, but not all, of the time...

--------------------------------------------------

Special thanks and "hat tip" to TFP readers, such as David, Ned, and Oz, who inspired this post by sharing your thoughts in Comments, and by provoking my own thoughts as I reply to those Comments...

Comments

[Leonardo]

I personally think we're still somewhere in between the denial and fear stage. When you read not long ago about a security guard at a shopping mall killed by being trampled on, does this suggest that we've past capitulation or even despondency? I think not.

Your movement along the curve mimics the speed at which current financial markets have been unfolding. Whilst this may hold true for what markets participant feel, it is not however, the speed with which the real economy evolves. We have just started to see unemployment (substantially) rise. Further, there is no telling whether we may remain stuck at a particular level for some time.

This is going to be one long affair unfortunately.....

[Kent @ The Financial Philosopher]

Leonardo:

I will not disagree with your comment, primarily because I would never pretend to know what the future holds, and opinions are never "wrong."

The beauty (and wisdom) of philosophy, in my humble opinion, is that it is a process of seeking the truth while never pretending to actually BE the truth. Philosophy asks questions -- it does not give answers. The "answers" for each individual to reach (and act upon) should be a result of their own inner-thought and value systems...

With regard to the security guard being trampled, one could argue the mob was not acting in greed or even haste to spend their money -- they were acting out of irrational and blind desparation to get a "deal" on something they don't need.

Furthermore, the problem with your assumption is that it is not "scientific," either. The only way we can reach a "scientific conclusion" is if we had another event to compare it with.

For example, in a "normal" economy, perhaps two people, rather than one, would have been killed by the mob? Or, perhaps in a "normal" economy the discounts would not have been quite as deep and the mob would have been less irrational and no one would have been killed? One could make several equally intelligent arguments here...

Also, history will show that the economy is weak; people are losing jobs; and mass redemptions in mutual funds will continue to occur well into the early stages of a stock market recovery...

The market sentiment cycle is certainly not scientific or a prudent forecast model. Emotions fluctuate and all market participants are not feeling the same emotions at the same time.

I find it difficult to believe that an overall characterization of investor herd sentiment could still be "denial" at this stage, although there are certainly a minority of market participants who are in denial now that stocks will go lower, just as there are people in denial that stocks can go higher months and even years into the healthiest of bull markets.

To place my thoughts and investment policies into perspective (for my own money and that of my clients), is that I won't place one penny of money needed within three years into stocks.

With that said, do you believe that stocks will outperform cash over the next three years?

The bottom line is that investing (or using an investment adviser) is a personal decision.

Personally, I believe (and will invest as if) stocks will outperform cash over the next 36 months. I would not (and did not), however, make the same assessment 36 months ago...

The next 12 to 18 months is a bit more difficult (and imprudent) to "forecast," no matter which direction one would venture to wager...

Thanks for sharing your thoughts...

[Oz]

That's a very neat sinewave of the emotional rollercoaster ride of investing. However, I'm prone to believe that life is a lot messier than that picture suggests. The ripples from the financial crisis are still making it's way through the economy as month after month, businesses bleed money, people lose jobs, and financing becomes more difficult. Worst would be to get stuck in a negative feedback loop (vicious cycle) that overshoots an equilibrium on the way down as much as we went over the top during the bullrun. This to me means that we may have no idea how long we're stuck in the fear-through-depression stages of that picture.

I recently read an interesting article about experimental economics. This is brand new to me since I didn't believe we could create lab conditions to test economic hypotheses, but they have with investor trading. The results are astonishing: subjects were given a security to trade, and any uncertainty was cleaned away with a guaranteed dividend paid out every few minutes. It's fundamental value can easily be determined by calculating the sum of dividends paid out by the security. Investors would go through several rounds of trading, and each time, without fail, they would create a bubble and then proceed to crash.

http://www.theatlantic.com/doc/print/200812/financial-bubbles

Outside of the lab, my greatest concern is that populations grow on economies, and can crash with them. And we now have many many people to take care of, both in good and bad times. Do we have the resources and patience to make it through this? I know I was running low on both while looking for work after college. Now we multiply that by every unemployed or discouraged person and we have a societal issue. I actually believe we have the resources to support everybody, but distributed unequally, but between now and the point of return, things are going to get messy.

Thanks again for provoking our thoughts and minds, Kent.

[Kent @ The Financial Philosopher]

Oz:

You make great points and I do not disagree.

Life certainly is not neat, orderly and predictable as the market sentiment graph suggests.

I believe there are elements of nature involved with anything and everything touched by an entity coming from it (i.e. humans), and the movement of the economy and stock market is no different -- it is cyclical.

As I stated in the post, market sentiment will fluctuate and will often have a longer duration on certain sentiments longer than others.

It is possible that we will bounce between fear, panic, capitualtion, despondency, depression and hope for quite some time, just as we my linger on complacency and greed on the top of a given cycle...

All I know is that this cycle will end and a new one will begin...

"Nature never hurries, yet everythingn is accomplished." ~ Lau Tzu

[Money Services]

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.

[Penny Stocks]

I greatly enjoyed looking through your blog and found an informative one for finance related topics.

[Penny Stock Investing]

I must say this is a great article i enjoyed reading it keep the good work.