From Bull to Bear – It’s All in Our Heads


Today I’m going to talk about psychology. Investor psychology. If you can get your head around how this important variable effects assets prices, you’ll have a better understanding of why markets are acting the way they are right now.

Let’s take Friday’s non-farm payrolls report in the US as an example. It came in at 173,000 jobs created for the month of August, down from 245,000 the month before and much less than the 220,000 expected.

Not long ago, the market would have greeted this number with a cheer. The reasoning being that employment growth is too weak for the Fed to raise rates. Great news!

So why didn’t the market celebrate this weaker-than expected number? Put simply, it’s to do with investor psychology. The mood of the market is changing. Investors (traders or gamblers, to be more accurate) no longer see the world through rose-coloured glasses.

Instead, they’re starting to see and price in the risks that have existed for some time. They react to each data release with caution rather than celebration. For the time being at least, ‘the market’ accepts that it has no idea how the short term future will play out.

Ignore the fact that the market never knows how the future will play out. It’s all about belief. If it believes things will be ok, then it will pay higher prices for stocks than if it accepts that it doesn’t know.

What was it that caused the market to turn? Did everyone start reading Vern Gowdie’s articles and recent book, The End of Australia, and realise he was onto something?

As much as I like Vern’s stuff, it’s fair to say that no one takes any notice of those giving warnings when stock prices are on the rise. It’s only in hindsight their words become prophetic. Although Vern’s analysis still contains plenty of foresight. He thinks stocks have a long way to fall. You can read Vern’s argument here.

You saw another, less obvious example, of the power of investor psychology at play over the weekend. At the G20 Summit in the Turkish capital of Ankara, the world’s economic rulers did their best to list investors’ spirits. From the Financial Times:

Finance ministers from the G20 nations have insisted the global economy has nothing to fear from a China slowdown as they tried to dispel the pall of gloom that has been cast by sagging growth and market turmoil.

At the end of a two-day meeting in Turkey the representatives, accounting for 85 per cent of the world’s output, expressed confidence in the economic forecast in spite of mounting evidence that global growth is falling short of expectations.’

Yes, China is all good. No need to worry about it folks, the bigwigs at the G20 say so. And they wouldn’t lie, would they?

Wolfgang Schäuble, German finance minister, said the G20 agreed there was no reason to fret over slower Chinese growth, while Pierre Moscovici, the EU Commissioner for economic affairs, praised “the absolute determination of the [Chinese] authorities to sustain growth”.’

Well, China were ‘absolutely determined’ to stop their stock market bubble from bursting too. How did that go? Have a look at the chart of the Shanghai Composite Index below. What do you think?

Source: StockCharts

The first leg down occurred in June. In early July, China’s all-powerful authorities declared a whole range of measures to halt the bust. It worked for a little while, and cost a lot of money, but even the Chinese Communist Party can’t fight the trend.

In August stocks broke lower as the government gave up trying to support the market. Sure stock prices could bounce higher from here, but the overall trend is firmly down. I wouldn’t be surprised to see the whole China bubble deflated by 2016. That means you could see the index back down to 2,250 before the bust exhausts itself next year.

But China’s officials don’t think so. Their focus is now on propping up investor sentiment, rather than stock prices. As Bloomberg reports from the G20 conference:

Volatility in China’s stock markets is nearing its end, a central bank official said, after Group of 20 finance chiefs flagged concerns about potential global spillovers.

The Chinese government has intervened to prevent the “free fall” of the stock market even as it feels an adjustment is “normal,” Zhu Jun, Director-General in the People’s Bank of China’s international department said in an interview on Saturday in Ankara.

“We think it’s pretty close to the end,” Zhu said, referring to the stock-market volatility. “To some extent the leverage in the market has been decreased substantially and we think there would be no systemic risk.”

Phew…that’s good to know.

Look, it doesn’t matter what these economic and market salesman have to say. The point is, that they cannot alter the underlying trend. And what you’re seeing unfold now is a shift in underlying trend around the world from bullish to bearish.

There’s no way of knowing how long this bearish trend will persist. But being aware of it, instead of just falling for the ‘stocks are cheap, buy the dip’ mentality, will give you a head start against most other investors.

This ‘buy the dip’ mentality comes from a still strong belief in central banks’ ability to prop markets up. Mostly, it’s a belief in the US Federal Reserve. But the Fed is on an interest rate tightening path. They’re not just going to turn on a dime at start printing money.

They realise the only thing they have left is credibility. Going from an expected interest rate rise to another round of quantitative easing in the blink of an eye would tear that credibility to shreds.

In other words, you’d need to see the Dow Jones index lose another few thousand points before the Fed thinks about changing direction.

And where will investor psychology be then?


Greg Canavan

Editor, The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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