It’s true that fundamentals drive the market in the long term. In the short term, though, pretty much anything can happen.
Traders can likely make more money focusing on emotions and illusions rather than on numbers. The madness of crowds can drive stock prices farther and faster (up or down) much more dramatically than earnings can. This can be a gold mine for those focusing on volatility. Psychology courses, in this case, are more important than business classes.
Every time I start believing the efficient market hypothesis, something crazy happens to throw all efficiency out the window. A company will report earnings and its stock will soar (or decline) 40 per cent in a day. If the market was so efficient, how does that even happen?
Let’s look at five possible reasons. Some you will have heard of, some, maybe not, but all can be big influences on the market and your investment portfolio.
Most investors know about greed, and have probably experienced it themselves. Have you ever let a winning stock run too much, only to hold it into a precipitous decline? We all have. On the way up, investors get visions of riches in their heads. Have you ever spent the profits on a rising stock in your head (or for real) before you even sell that stock?
Greed works differently than fear, discussed next. Have you ever seen panic buying ? Not often, that’s for sure. Short sellers might, but regular investors almost never panic buy. Simply put, the pleasant sensation of making money is not as powerful as the pain of possibly losing money.
We are mixing fear and the fear of missing out (FOMO) together here. Of course, one emotion causes stocks to go down, and one causes stocks to go up. But both tend to be largely irrational, creating opportunities for investors who understand what’s going on.
Occasionally, the market goes into full-on panic mode. We saw it last year several times as inflation threatened to take root and destroy portfolios. We see it every time there is a new war, and sometimes from just one or two words in a United States Federal Reserve statement. Fear is a very big driver in the market. If you are borrowing money to invest, your portfolio can be destroyed very quickly in a falling market.
But the fear of losing profits can be more powerful than the fear of losing money. Investors never like to book an actual loss. This is an admission that they were wrong. But boy oh boy, investors have no trouble booking a profit. If they are up 50 per cent on a stock and it starts falling, investors can pull the selling trigger very, very quickly.
Aside from straight fear, FOMO is also a big market driver. We see it in sector runs, or when a company soars in value after making a big discovery. Investors will often completely ignore fundamentals to get in on the action. This, of course, can be very dangerous. But it doesn’t stop people from falling all over themselves to buy more of a surging stock.
The money illusion acts a bit differently, since it can influence individual behaviours, not just market behaviour. For example, consumers tend to wax nostalgic about the good old days when prices were cheaper. They focus on nominal prices rather than real prices. In other words, we know prices have gone up over the past 30 years, but so have wages.
The money illusion makes people hate inflation, even though it benefits them. Inflation fears may make them adjust their consumer shopping habits even though their houses and investment portfolios have soared in value as well.
How does this impact markets? Well, as we have seen in other cycles, inflation does not always result in lower stock markets. In inflationary times, companies can increase their prices, too, and profit margins may not be impacted. Essentially, sometimes (not always), the fear is stronger than the reality.
The frequency illusion is a combination of selective attention and confirmation bias. Again, let’s use inflation as an example. For 16 months now, all we’ve heard about is inflation, inflation, inflation. Investors have reacted to every single consumer price index (CPI) data point. Inflation was low for 30 years, and investors more or less ignored it. But now, our brains have been alerted to it. Since we are more aware of it, we look for signs of it. This is confirmation bias.
Overall, consumers overestimate the frequency and degree of price increases because that’s all they are looking for. They can overestimate the potential problem, believing price increases are far more common than they are. Then we get a benign inflation reading (as we did on Tuesday in the U.S.) and stocks soar, because investors are surprised that inflation is essentially disappearing now.
Have you ever owned a stock that reported bad results and suddenly declined 30 per cent? How did that make you feel? We bet some swear words were involved. Now, imagine you are a fund manager with five million shares of that losing stock. Your clients are going to wonder why you ever owned it at all. Your boss is going to question your competency. Suddenly, you have some external pressures to deal with. Often, investors and fund managers will react in anger.
You might have once said, “I’m just gonna sell that loser, I don’t care.” Managers do the same thing, and dump millions of shares into a market where no one wants them. The result: stocks sometimes get massively oversold on bad news. If you are taking a loss, if it is for your sanity, for tax-loss purposes or to clean out a loser, price and valuation don’t seem to matter anymore. You just want out of a problem. It’s like being in an argument with your spouse, and slamming the door on your way out.
With a stock, though, you don’t often come back. You’re just gone. This can create great trading and investment opportunities for investors going the other way. Now, we are big believers in momentum, and certainly dislike negative momentum, but we also won’t ignore fundamentals just because we are angry. An earnings miss might have valid reasons, such as a delayed contract or two. A miss and a drop don’t need to create anger: they just need to be investigated further.
Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)
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