This is part two of a series on market psychology, specifically on market sentiment. Click here for part one on decoding the market’s state of mind.
In a perfect world, the valuations of various investments would always depend on quantitative numbers. The stocks of companies that are growing would always climb in proportion with their growth rates, no more, no less. However, that’s not actually how the markets work. Investing is much more complicated than just fundamentals. Macroeconomic events and fear play significant roles in which way the markets are moving.
The behavior of the market often tracks the way investors feel about investing at a particular time. The problem with this is that the market’s direction is largely based on qualitative views that can change at a moment’s notice rather than fundamental values that demonstrate which direction businesses and the economy are moving. Some qualitative views depend on quantitative factors like interest rates, but many do not. Investors simply decide what they are willing to pay for a particular asset based on how they feel about whatever is happening at the present time.
Benjamin Graham’s allegory of Mr. Market from his book The Intelligent Investor is quite apt when talking about market psychology. The basic idea is that every investor has a business partner called Mr. Market, who constantly offers to sell his share of the business or buy their share of the business. The offer is constantly in flux, just as the market is, so investors can buy or sell at any given time based on how Mr. Market is feeling at a particular moment.
Warren Buffett on Black Monday
Although all the market’s movements are based on what investors are feeling at any given moment, one of the most extreme examples of what market sentiment can do when all logic departs is Black Monday, which was Oct. 19, 1987. The Dow Jones Industrial Average plummeted more than 20% in a single trading day, and by the end of the month, most major indices had declined by more than 20%. It was clear that mass panic gripped the market that month, although a precise reason was not found.
Numerous experts and traders have theorized about what caused the massive crash and the psychology behind it. One of the most interesting explanations came from Warren Buffett in his annual letter to Berkshire Hathaway investors for 1987. His explanation illustrates how market psychology affects trading. He described Mr. Market’s behavior that year as “a manic rampage until October” before “a sudden, massive seizure” on Black Monday. We’ve certainly seen this same sort of behavior since then, and we will probably see it again. Nearly the only thing about the market that we can be certain of is that there will always be at least a meaningful amount of uncertainty.
Buffett blamed “professional” investors for most of the uproar in October 1987 because instead of focusing on what businesses would likely do in the coming years, professional money managers were focusing on what they expected other traders to do in the coming days. Fundamentals were thrown out the window entirely in favor of what other investors might be feeling.
However, by behaving rationally when everyone else is behaving irrationally, it is possible to benefit from such times of market turmoil. Buffett noted that psychological pressure can be strong, but investors do not have to give in to it.
“Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves,” Buffett wrote. “He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.”
If Mr. Market feels bullish, the tendency is to reciprocate with excited buying, and if he feels fearful, the tendency might be to sell or at least stop buying. If Mr. Market appears to be losing his head for no apparent reason, then many investors follow suit, although that’s generally not the best option. Maintaining a level head when other investors are abandoning ship is difficult, but it can be done with a basic understanding of market psychology.
How to gauge market sentiment
Black Monday demonstrates how qualitative views can change at a moment’s notice with no logic to them. Doing the same thing everyone else is doing may cause your portfolio to underperform, but running against the grain can present compelling opportunities for trading if it is done correctly. Thus, being able to read market sentiment and use it to your advantage can and should be a part of your portfolio strategy. There are several ways to gauge market sentiment and use it to inform your investing strategy.
Perhaps the most well-known is the VIX, which measures volatility and is sometimes called the fear index. When the VIX rises, it means volatility is increasing, and investors are feeling like they need more protection against risk. When the index falls, it means investors are less fearful because volatility isn’t expected to increase. The index is derived from options prices and was created by the Chicago Board Options Exchange (CBOE).
The High-Low Index is another way to tell whether investors are generally buying or selling. When the index climbs over 50, it means more stocks are hitting 52-week highs, and when it falls below 50, it means more stocks are hitting 52-week lows. Generally, a reading higher than 70 suggests the stock market is heading upward, while anything under 30 indicates that stocks are trending lower.
Another way to gauge market sentiment is the Acertus Market Sentiment Indicator (AMSI). The indicator changes each month, ranging from zero, which means extreme fear, to 100, which means extreme greed. The index takes into account stock market valuations, market psychology, recent historical risk, credit risk and systemic financial risk. All of these factors are used to estimate the way investors might feel any given month.
Several factors play into the direction in which each of these market gauges moves. The next article in this series will focus on headline risks and how the news plays a major role in how investors feel about the trades they are making each day.