Extreme Fear and Greed in the Stock Market

Dave Young

The S&P 500 is down about 6.66 percent year-to-date. From its peak in April, it has dropped a total of 14.5 percent from peak to trough.
Our conservative portfolio, Managed Income, has done well despite the difficult market. It s still up 0.48 percent year-to-date. Our growth portfolio, Top Flight, has done relatively well. It is down only 7.74 percent for the same period. At the end of the quarter, our investment models put Top Flight 20 percent in cash and 80 percent invested.

What is going on with the stock market?
I am asked this question on a regular basis. One day the Dow is down 300 points, and the next day it is up 300. Volatility levels have been extreme the past couple of months. In the short-term that can be a little unnerving to say the least.

In order to make good investment decisions, this question has to be addressed on two fronts.

-First, what is the market doing? (Going up or going down.)

-Second, do fundamentals justify the direction the market is moving?

The markets are continuously going through small up and down cycles within longer-term trends. Every time the market starts a downward cycle we attempt to determine if this is the beginning of the long-term trend turning downward. If it is, we should reduce market exposure. If it is not, we should stay fully invested.

If we sell out too early, we will miss out on returns if the market continues its upward trend. If we sell out too late, we may take more of a capital loss than we want to as the market declines. Investing when everyone is optimistic and selling out when everyone is scared is a recipe for buying high and selling low. It is also a great way to generate horrible long-term returns.

It is vital for us to make the right investment decisions, because if we are wrong, it negatively affects our long-term returns. A bad move not only negatively affects our clients, but it also hurts Paragon because our interests are identically matched with our clients’. If our clients are not happy with us, they can leave at any time without paying any surrender charges. This is unique in the financial industry. Most financial products have a penalty for leaving early. Because our clients’ investment success is very important to us, we place the utmost importance on our investment performance.

Fortunately, we have developed several investment models that take emotion out of the process and help us determine where we are in the market cycle. Also, we rely heavily on sector rotation models, which have done a good job of moving us towards those areas of the market that are holding up when the overall market is declining. While they are not always right, our long-term track record indicates that our models have done well at keeping us on the right side of things. From January 1, 1998 through June 30, 2010, our growth portfolio, Top Flight, has generated a net total return of 325 percent versus 32 percent for the S&P 500. (See full track record and disclosures on page 7.)

EMOTIONS RULE

It is important to understand the role of emotions in investing. There is an entire field of study dedicated to analyzing the correlation between emotions and investing called Behavioral Finance. Emotions always play a big part in investor’s actions. In a perfect world they should not have an impact, but in real life they do. It is the human element. If investors would take their emotions out of the picture they would be much more successful.

After going up over 70 percent in 13 months, from March 2009 to April 2010, the market turned down at the end of April. Since the end of April we have seen huge increases in volatility with the Dow Industrials posting a 12.4 percent drop in just 42 days.

Why did the market drop so sharply and quickly? It was not because of the fundamentals. Fundamentals were responsible for the steady rally over the previous 13 months, and those fundamentals have not changed that much. It was because traders were very nervous. It was a case of high emotions and extreme fear. Investors and traders still have a vivid memory of the nasty bear market in 2008. Even though fundamentals have changed significantly since that bear market, they still are looking over their shoulder and fearful that we may see a rerun of that nasty bear market. It is interesting that from a chart perspective, the recent decline has been much shorter but the angle of the drop mirrors the angle of the drop in 2008.

As the market rallied over the previous 13 months, each day we listened to all of the reasons why the market will not recover, and how we are just setting up for a disaster. When you consider that 70 percent of retail investors completely missed out on the sharp recovery off of the bottom, you start to understand why there is so much of the negative highlighted constantly in the press.

Obviously, the investors who missed the move completely do not want to be wrong. Their only hope is to imagine they were not wrong, and they did not miss out on a huge 74 percent upward move. They need the market to go back down so that they can be invested the next time around. In short, they hope the market will go back down. With that hope they grab onto and magnify every negative piece of news imaginable. They do not look at the big picture. They only focus on the negative that will reinforce what they subconsciously hope will happen.

There are all kinds of scary issues investors are concerned about. It is a never ending list: Europe’s problems, the oil spill in the Gulf, a jobless recovery, Washington’s political insanity, the dollar, illegal immigration, the flash crash, potential inflation, a possible double dip recession, etc. We can talk for days if we want to focus on the negatives. As long as I have been investing, scared investors have endlessly spouted the negatives. If I would have listened to them 25 years ago, I would have taken my money and buried it in the ground.

In the short-term, markets can be pushed all over the place by the emotions of extreme fear and greed. In the long-term, corporate profits drive stock prices. Where are corporate profits in the midst of all the doom and gloom? They are up about 200 percent from where they were a year ago. Estimates are showing them coming in at $80 this year and $90 next year. If those estimates are correct, that puts price earnings ratios at very low levels of 13 times this year’s earnings, and 11 times next year’s earnings.

In short, corporate profits are very strong, and stock valuations are still below their long-term averages. In addition, there are very few good places for investors to put their money right now. Our interpretation of the current data is that a double dip recession will not occur, and much of the fear surrounding it will eventually fade away. However, in the mean time, who knows how far emotional investors will let their fear and greed push the market around. We’ll leave that to our investment models to determine.

WHAT SHOULD YOU DO?

For investors, the only way to keep your sanity and ultimately make money is to be invested according to your risk tolerance and keep a long-term perspective. If you are worried or stressed, you are probably invested more aggressively than you should be. The danger of investing to aggressively is that you will likely want to bail out at the worst possible time, and consequently miss out on the long-term returns you seek. Our job is to help you create wealth and keep you positioned in the best way possible in order to capture those long-term returns.
As always, if you have any questions or concerns regarding your account feel free to call or email us.