The Impact of Emotion on Stock Prices

The Aussie market is in a spot of bother. Since peaking at the end of August, the benchmark index, the S&P 200, is down 5.3%. There are fundamental reasons for that which I covered yesterday.

The two main ones as far as I can see are the looming rise of Bill Shorten to national leadership (gulp!) and US-China trade tensions, which will disadvantage Australia. You can add rising energy costs to that, which I’ll get to later.

But there is another aspect of markets that often gets overlooked. The fundamentals are one thing, but you cannot assess them in isolation. Fundamentals impact investor psychology, and investor psychology has a big impact on asset prices.

I’ve been writing a book on this and have recently reviewed the draft, so the concept of investor emotions having an impact on price is top of mind for me.

And a recent article in The Wall Street Journal reinforced this important consideration. The article was a review of Howard Marks’ latest book, Mastering the Market Cycle. Marks is a somewhat legendary hedge fund manager and runs the Oaktree Capital business.

While the title of the book is a little misleading — no one can master the cycle and I doubt Marks believes it either — the message is important. As the reviewer, Burton G Malkiel writes:

“The greatest source of investment risk” is not, he writes, “negative economic developments” but “when risk aversion and caution evaporate.”

“Mastering the Market Cycle” comes down to the insights of behavioral finance. We know that investors tend to put money into the market at tops, when everyone is optimistic, and take the money out at bottoms, when panic is widespread. The key to investment success is to do the opposite and keep one’s emotions—aggressiveness and defensiveness—in balance.’

And, to reinforce the point:

“The greatest source of investment risk,” he says, “is the belief that there is no risk.” When prices start to decline, investors panic and risk aversion goes from inadequate to excessive. Thus the reward for bearing risk is greatest just when people refuse to bear it. “The fluctuation—or inconstancy—in attitudes toward risk,” Mr. Marks writes, is “the cause or exacerbator” of cycles. At the bottom of the market lenders refuse to offer credit even to credit-worthy borrowers.’

How emotion dictates a stocks price

Over the past two days, there has been a marked shift in investor sentiment. Many stock prices that reflected an absence of risk have now had a bit more risk priced in.

We don’t know if this is the end of the cycle of investor optimism, or whether it’s a minor adjustment. The only defence against getting caught by such an adjustment is to invest with an eye on valuations.

An appropriately valued stock, by definition, will have an absence of investor optimism priced in. Optimism is what sends a stock price into overvalued territory.

Having said that, the low level of interest rates in Australia will at least provide fundamental support, which in turn should ensure investor psychology doesn’t turn to full-blown pessimism.

Aussie government 10-year bond yields currently sit around 2.8%. This is equivalent to a price-earnings (P/E) multiple of nearly 36-times. The ASX 200 currently trades around 16-times.

That pricing favours stocks, at least based on a fundamental, or rational view. But as I just pointed out, that’s not what the market is about. You also have to take into account investor emotion. That could be in the process of turning for the worse.

Aussie economic expert outlines the five ASX stocks posing the biggest threat to your family wealth. Get the names here.

If business is hurting, consumers are too

The other issue hurting stocks right now is energy prices. Oil is at multi-year highs and petrol prices are an additional tax on the consumer. This is occurring at the same time as increasing electricity and gas bills for businesses and consumers. As The Australian reports:

Australian manufacturers could be forced to halt operations as a fresh surge in wholesale gas and power prices threaten the viability of heavy industry and could puncture the government’s ambitions of solving the energy crisis.

The Australian Industry Group, which represents 60,000 manufacturing and industrial businesses, said the expected rise of gas prices on the east coast this summer back to near crisis levels threatens to dent the economy and reflects the government’s failure to sanction sound energy policies.’

If business is hurting, then you can bet consumers are too. You can see this in the chart below. It shows the ASX 200 Consumer Discretionary Index, which has declined sharply in the past few months.

MoneyMorning 10-10-18

Source: Optuma
[Click to open new window]

This is another example of a big shift in psychology. Investors have gone from bullish to bearish in the blink of an eye. This is despite the prevalence of rising energy costs for a while now.

Whether this recent shift is the start of something bigger depends much on what happens in the US. Right now, the major indices there remain in strong upward trends. That should provide some comfort.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity

PS: Discover why these five household-name stocks could be the first to lose you money when Aussie stocks drop dramatically. Free report available now.


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing. He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’. That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors. And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis. Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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