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Thursday, 17 September 2009

The Herding Effect - Why Investors Are Usually Wrong

By Simon Maierhofer

It has been said that there are at least three versions of the truth. There is your truth, there is my truth and there is 'the truth' that usually lies somewhere in between. This illustrates that preconceived ideas often distort the actual truth. Two or more people may look at the same subject and yet see different things.

Some look at stocks and see a new bull market as part of a V-shaped recovery. Others look at the same stocks and see a W-shaped recovery. Yet, others look at the same stocks and conclude the worst is yet to come.

Since there are so many opinions formed over the same subject, investors can come to one of two conclusions:

1) There is no consistency among the total sum of conclusions, therefore it is impossible to ascertain an outcome with any degree of certainty - investing is basically an arbitrary process.

2) There are certain indicators with a track record of accuracy. Those indicators point towards the real direction without being clouded by preconceived viewpoints.

If you have come to the conclusion that investing is an arbitrary process (conclusion No. 1), you should seriously re-examine why you are invested in the first place.

If you believe that there exist indicators which allow you to ascertain the market's direction, you will find it interesting to see what those indicators are and how they should be applied correctly.

The first and most important lesson to be learned is that the vast majority of investors (individuals and institutions) are usually wrong, that's right; wrong. Here's why:

The herding effect - apparent truth

The herding effect could be explained in one sentence: If it's too apparent, it's apparently wrong.

Herding is a social behavior; in fact, it is a phenomenon that reflects a contagious emotional, collective feeling. This feeling (positive or negative) spreads among investors progressively. If this doesn't make sense quite yet, hang in there - it will be the single most important contributor to your investment success.

Rather than explaining the herding effect with words, let's take a look at a real life example.

After two decades of relentless buying and unbridled enthusiasm surrounded the technology sector (NYSEArca: XLK - News), 65.7% of individual investors (according to AAII) felt bullish about stocks in March 2000, while only 11.1% felt bearish. Just about at that time, the Nasdaq (Nasdaq: ^IXIC) topped and started a steep decline.

In October 2002, when the Dow Jones (NYSEArca: DIA - News) and S&P 500 (NYSEArca: SPY - News) traded around 7,500 and 800, only 24.5% of investors felt that stocks would go up, while 54.8% felt that stocks would drop further. It was at exactly that time that stocks bottomed. Even though this could have been a foundation for a huge rally, savvy investors knew that the 2002 low was doomed to be broken. (More about that a bit later)

Leading up to the 2007 all-time highs, the Dow Jones (DJI: ^DJI) and S&P 500 Index (SNP: ^GSPC) rallied nearly 50% from the 2002 lows. On October 16, 2007 - right as the stock market peaked - bullish investors reached record levels of 54.6%. Bearish investors, soon to be redeemed, made up only 16.5%. The same happened at the 2005 bust of the real estate (NYSEArca: IYR - News) bubble and 2008 top in oil prices (NYSEArca: USO - News).

Guess what happened in March 2009? Ranking at 18.9%, bullish investors were nearly non-existent. More than 70% of all investors had a bearish disposition. If you thought that professional investment advisors did better, consider the following: 47.20% of advisors thought stocks would drop further, while only 26.4% believed better times are ahead.

Knowing that, due to the herding mentality, investor pessimism climaxes at times of major market bottoms (and based on a composite of many other indicators), the ETF Profit Strategy Newsletter issued a Trend Change Alert on March 2nd. This Trend Change alert predicted that the market was about to start the biggest rally since the 2007 all-time highs with gains of about 40%. The target range given for a top of this rally was Dow 9,000 to 10,000.

At a time when investors wanted to sell and advisors told them to sell, the ETF Profit Strategy Newsletter said: 'BUY!' Recommended ETFs such as the Financial Select Sector SPDRs (NYSEArca: XLF - News), Ultra Financial ProShares (NYSEArca: UYG - News), and Ultra S&P 500 ProShares (NYSEArca: SSO - News) have gained 100% and more.

Before we discuss investor and advisor sentiment today, let's take a look at the distorted truth.

The Wall Street effect - distorted truth

Truth often becomes distorted when emotions are involved. Depending on the environment (positive or negative) at the time, the same event may cause different emotions.

To illustrate: You are watching your favorite football team. The umpire makes an incorrect, unfavorable call while your team is winning, but you don't care too much. On the other hand, the umpire makes an incorrect, unfavorable call while your team is losing, and you are ready to blow up.

There's been much bad news about job losses, foreclosures, the next wave of defaulting loans, etc. But nobody cares because the market is going up. In fact, nobody will care as long as the market continues to go up.

Going back to the above football illustration; you wouldn't care about the umpire's call as long as your team goes on to win, in fact you'd probably forget about it. If, on the other hand, your team goes on to lose, the loss will probably be linked to the umpire's mistake.

So it goes with the stock market. Bad news doesn't matter until stocks turn down. As we've seen in 2008 and early 2009, a bear market is the best auditor. Once the sentiment turns negative, it brings out news you wish could have been hidden forever.

The logical conclusion is that news feeds on itself. Good news usually climaxes towards the market top, while bad news reaches its crescendo at a market bottom. As a mental exercise, think back to the second and third quarter of 2007. Wasn't the general consensus that the market will continue to move up indefinitely? Conversely, think back six months ago when the Dow was below 7,000. How many people can you remember saying that the Dow will be close to 10,000 later on in 2009?

Today's investor sentiment

As discussed earlier, major market tops are usually marked by the majority of investors being bullish. In October 2007, 54.8% of investors and 62% of investment advisors were bullish. In August as many as 51% of investors and 51.60% of investment advisors, were bullish. Keep in mind, though, that stocks are still 30% below 2007 levels and have just come off a 50% rally.

Why the 2002 market bottom did not last

The Dow Jones fell to 7,500 in October 2002 and dropped below 6,500 in March 2009. How could savvy investors have known that the 2002 lows were not the bottom?

An analysis of bear markets of historic proportions shows that true market bottoms always coincide with rock-bottom valuations. Unless valuations reach levels that the market feels are fair, any subsequent rally is doomed to fail, just as a house built on sand won't last.

The easiest, yet most effective measures of valuation are P/E ratios and dividend yields. These measures have been reset to fair valuation levels every time the market has found a true bottom. In fact, based on those historic bottom levels, it is possible to calculate a market bottom for this bear market.

A sobering outlook

A look at the numbers shows that P/E levels and dividend yields have not yet reached fair valuations. In fact, the market is grossly overvalued still. Current investor optimism - the herding effect - clearly points towards a major market top to be reached sooner, rather than later.

The ETF Profit Strategy Newsletter features a detailed analysis of P/E ratios, dividend yields, investor sentiment, and other trustworthy indicators. Indicative of their implications, we've actually named the four most reliable indicators the 'Four Horsemen.' The most recent newsletter includes a target range for the ultimate market bottom, along with a target range for the top of this rally.

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