It’s no secret that the market has a mind of its own, and there are many aspects of this psychology. Investors themselves drive the market’s mindset by flocking in one direction en masse and crowding positions or by having knee-jerk reactions to headlines. Additionally, investors and traders who have spent any time at all studying the market have come to expect the market psychology to behave in certain ways when specific things happen.
If the current bull market and expansion have taught us anything, it’s that Mr. Market doesn’t always behave the way he historically has. Irrational exuberance has sent the markets up, up and away, leaving some investors believing volatility may never return. However, some elements of the market’s psychology remain in place even though conditions haven’t always played out as we would expect.
Many factors play a role in Mr. Market’s psychology, and understanding each of these factors can help you see what’s happening in the market so you can adjust your trading decisions. This series will examine the many aspects of market psychology, how investor sentiment feeds into asset prices, and why various assets usually behave in certain ways during specific market events and macroeconomic conditions.
Each factor pits investor sentiment against fundamentals because after all, if investors always behaved rationally, the market would very rarely run to extremes.
Sentiment versus fundamentals
Perhaps the best illustration of what happens when sentiment veers away from fundamentals is Black Monday, which was Oct. 19, 1987. The Dow Jones Industrial Average plunged by more than 20% in only one day, and by the end of the month, most major indices had declined by more than 20%. No one really knows or understands why the markets suddenly plunged, although some have tried to explain it. However, there is generally one common theme in all the theories: mass panic.
Just as the Black Monday crash can be attributed to investor sentiment rather than fundamentals, so can other market trends and movements. The psychology of the market essentially hinges on how investors think and feel. Investor psychology dictates market psychology, and it does so in several different ways.
Perhaps one of the biggest dictators of sentiment is news headlines. Investors who handle their own trading are in peril of making decisions based on their emotions. This is an especially big concern during times of uncertainty because investors may find themselves selling in fear of loss one moment and then buying the very next day because they’re worried about missing out.
Knee-jerk reactions are almost never wise moves. The ongoing trade war between the U.S. and China has been a point of tension for many months, and the market displays clear movements every time any action is taken or a remark is made. The problem with making decisions based on the trade war headlines is the fact that the situation is constantly in flux. The U.S. and China may appear close to a deal one day, only to impose new sanctions on each other the following week.
Herd mentality and crowding
An issue that grows out of headline risks is crowding or the herd mentality. The current momentum rally is an excellent example of this issue. The more investors bought the FANG stocks (Facebook, Amazon, Netflix and Alphabet (GOOGL)), the more desired they became. Headline concerns like the scrutiny over Facebook’s privacy practices and regulatory concerns have done little to derail the momentum the company’s stock has been on.
However, one problem with this is that it creates a lot of crowding in these names. Thus, when investors finally do come to their senses over the excessively high multiples of these crowded positions, they could drop hard and fast as everyone abandons ship at the same time.
The stock market isn’t the only place where herd mentality can take hold. The cryptocurrency market has been another solid example of this as bitcoin’s price approached $20,000 in late 2017 before plunging the next year as the market grew tired of the fad.
Buy low, sell high
The ultimate goal of investing is to buy low and sell high, but many investors fail to do this without even realizing it. Perhaps one of the biggest reasons a portfolio underperforms is because investors buy while a stock is on the rise and then sell when it drops. This issue also hinges on headline risks and plays off the two extremes of greed and fear.
Warren Buffett advises, “Be fearful when others are greedy and greedy when others are fearful.”
Investors who are able to separate their emotions from their trading decisions are more easily able to do this because they’re running in the opposite direction of the market. Instead of buying something because it’s hot or trendy, they’re buying something because it’s cheap. This is the classic value investing mindset. The basic idea is that the asset you’re buying when everyone else is selling will eventually go back up, and you will benefit because you bought it while it was cheap and sold it when it was expensive because everyone else wanted it.
The problem is that this is much easier said than done, especially when emotions and headlines get in the way. It’s easy to convince yourself that you’re missing out by selling what everyone else wants to buy, but if you have made your selections calmly and carefully, this will often not be the case.
Positive and negative asset correlations
Investor psychology also shapes the way the market responds to certain macroeconomic conditions. For example, when the U.S. dollar falls, gold prices usually go up, although this isn’t always the case. Stocks and bonds are usually negatively correlated, although there have been times like the fourth quarter of 2018 when virtually every asset class crashed.
The way investors view assets and their relationships to each other, the economy and other conditions impacts what these assets do when certain things happen. For example, gold is widely seen as a store of value during recessions or economic downturns. It’s essentially a modern-day equivalent of stuffing money under the mattress for safe keeping. Returning to the “buy low, sell high” point from above, the best time to buy gold is when prices are down because others are selling, while the time to sell is during a recession when prices go up. That may seem counterintuitive, but if you’re taking a long-term view of the market, it makes the most sense. If you time your purchases just right, you’ll buy gold toward the end of an economic expansion just before prices rise during the next recession. This is exactly what many investors are doing now as they await the end of this record-long bull market. As a result, gold prices have been rising steadily since the beginning of the year.
Interest rate psychology
Interest rates also affect market psychology. One of the main drivers of the current bull market has been the dovish Federal Reserve commentary. One reason the markets declined so steeply during the fourth quarter of 2018 was because the Fed started to take up a more hawkish view. However, in late January 2019, the tone shifted, and the central bank became more dovish. With that shift, the markets switched around and were off to the races once again after a relatively brief selloff.
Other assets move based on interest rates due to pure logic. For example, banks tend to do better with higher interest rates because they become more profitable, so bank stocks usually rise when the Fed hikes interest rates. One the other hand, it becomes more expensive to borrow money, which means high interest rates tend to be bad for low-yield bonds because demand for them declines. It doesn’t make much sense to hold bonds which have low yields when interest rates are high.
Finally, sometimes what carries the markets along is simple momentum. Driven by all the catalysts listed above, investors push asset prices along, driving each other to continue making the same decisions, regardless of whether the decisions are rational or not. This is exactly how bubbles develop in the market.
Many commentators and analysts have compared the current run in tech stocks to the dotcom bubble of 1999-2000. Investors got so excited about the prospect of the next wave of technology that they kept pushing stock prices higher and higher. We’re seeing something similar with tech unicorns today. Some hedge fund managers estimate that 80% of the companies which held initial public offerings in the first half of 2019 are going public while posting losses. One should question why investing in loss-making companies has become such a big trend, and one reason could be an extension of the momentum which has been carrying along other tech stocks in recent years.
The upcoming articles in this series will examine each of these aspects of market psychology in depth.