Give the stock-market experts a miss

12 Sept , 2008, DNA
"In a few months, I expect to see the stock market much higher than today."
You might have heard the above line on one of the business news channels just this morning. That's how common it has become, although the speaker may be forgiven for not understanding its historical importance enough.
The sentence was famously uttered by Irving Fisher, a famous American economist and a professor at the Yale University, just 14 days before the Wall Street crashed on October 29, 1929, the infamous "Black Tuesday."
Fisher was not the only one who got it wrong around then. The Harvard Economic Society, too, had ruled out the chances of a depression. But, as is well known, the US saw what is now known as the Great Depression following the stock market crash.
"Stock market crashes are often unforeseen for most people, especially economists," writes Didier Sornette in his book Why Stock Markets Crash - Critical Events in Complex Financial Systems.
Just before the stock market crashed in January this year, a stock brokerage firm had even predicted the Sensex hitting 25,000 by the year-end. While there is no ruling it out completely, such an event does appear highly improbable under the present circumstances.
And why do economists and other experts get their forecasts wrong? "A financial collapse has never happened when things looked bad," writes Sornette. "On the contrary, macroeconomic flows look good before crashes."
Try recalling what the macroeconomic numbers were at the time of the January market crash. The rate of inflation was at 4.36% compared with 12.34% now. The Index of Industrial Production was growing at 6.2% compared with 5.4% in the quarter ended June. No wonder the scaremongers were outnumbered by experts who remained positive until the markets crashed.
As Sornette writes, "Before every collapse, economists say the economy is in the best of all the worlds. Everything looks rosy, stock markets go up and up, macroeconomic flows (output, employment, etc) appear to be improving further and further."
So when a crash happens, it "catches most people, especially economists, totally by surprise. The good times are invariably extrapolated linearly into the future."
Sadly, the bullishness of these so-called experts before the crash rubs on to the "uninformed investors," who start investing in their "favourite stocks" towards the fag end of the bull market.
"The result of this behaviour would be a tendency for the favourite stocks' prices to move together more than would be predicted by their shared fundamental economic values," writes Sornette.
And most of this buying happens by looking at what others are buying. In this situation, investors behave like ants do, when they get separated from their colony. Ants, when they get separated from their colony, obey a simple rule: follow the ant in front of you. Much like the circular mills of the ants, investor decisions are made in a sequence. People, who invest in the stock market during a bull run assume that investing in the stock market is a good bet simply because some of the people they know have already done the same and made profits. Consequently, during a bull run, the stock market has more buyers than sellers. Expectedly, stock prices zoom up and more and more investors enter the market expecting the bull run to continue, fuelling an even greater price rise. Riding the bull wave, stock prices of fundamentally weak stocks also start to go up.
But this cannot keep happening forever and one fine day, things come to a stop. "If the tendency of traders to "imitate" their "friends" increases up to a certain point, called the "critical" point, many traders may place the same order (sell) at the same time, thus causing the crash," writes Sornette.
But why does this happen?
Economic theory tells us that, all things remaining the same, higher prices dampen demand and lower prices increase demand. But when the stock market witnesses a bull run, investors do not behave like normal consumers. As stock prices go up, the more stocks appeal to investors. This leads to investor psychology during a bull run that is detrimental to the investor as well as for the market. The normal law of demand fails to work.
As Maggie Mahar writes in Bull! A History of the Boom and Bust, 1982-2004, "In the normal course of things, higher prices dampen desire. When the lamb becomes too dear, consumers eat chicken; when the price of gasoline soars, people take fewer vacations. Conversely, lower prices usually whet our interest: colour TVs, VCRs, and cell phones become more popular as they became more affordable. But when the stock market soars, investors do not behave like consumers. Rather, they are consumed by stocks. Equities seem to appeal to the perversity of human desire. The more costly the prize, the greater the allure. So, at the height of the bull market, investors lust after the market's leaders. (Conversely, when the prize is too ready at hand, investors lose interest. At the bottom of the bear market, when equities are bargains, they go begging, like overly earnest, suitable suitors.)"
This ensures that investors buy high and sell low, the very reverse of the most basic investment principle. Given all this, a simple investment philosophy may be to go against the experts. If they are extremely bullish, you know its time to sell and vice versa.