Market Psychology and the Risk of Compacency

With the markets reaching new all-time highs, I thought it would be worthwhile to consider how far the markets have run from the lows after the “Great Recession” of 2008/2009. The S&P 500 bottomed out at 666. As of today (August 27, 2018), the S&P 500 is trading at about 2,890, which represents a 333% gain since March of 2009. We can review multiple metrics to try to determine if the current value of the market is “fair,” meaning that a reasonable argument can be made as to the chances of further upside. Regardless of opinions on the future prospects for the market, I thought I would share my thoughts on the current state of market psychology – how does the average investor view the stock market today, and can we glean any meaningful information from the psychology of the market?

Lately I have been thinking a lot about how long the current economic expansion and bull market for stocks has lasted. This is certainly the longest period of prosperity I have experienced in my 30 years in the investment management business. The Great Recession drove a large number of industry professionals out of the business. In fact, of all the people I started into the business with, and worked with in my early years, only a handful remain. Most left long ago, and of those that were still in the industry when the 2008 financial crisis hit, a very large percentage left as a direct result of the crisis. The result has been that the vast majority of current industry professionals have entered the industry post Great Recession. What that means in practical terms is that a very large percentage of industry professionals have only experienced bull market conditions and economic expansion throughout their entire careers.

Likewise, most investors either have only been investing for the past ten years or less, or have become complacent because the bull market has lasted so long that their perception of what is “normal” for the stock market has become skewed. A simple analogy will make my point – a turkey wakes up every morning in his comfortable straw bed. The farmer brings the turkey his food. The turkey walks outside and enjoys the warm sunshine with the other animals. Every day is the same – he wakes, eats, enjoys the sun or the occasional rain shower, goes to sleep, and then repeats. This is his normal routine, day in day out… until Thanksgiving. For people, normal is that every year, we have Thanksgiving, and every year we know what happens to turkeys. So what is really normal? The same can be said for people who live in New Orleans (or anywhere else that natural disasters strike on a regular basis). In New Orleans, residents can go for years without experiencing a major hurricane. But if you look at a longer time scale, it is clear that hurricanes strike New Orleans on a regular basis; always have, always will. The stock market is no different.

My point is that it is very easy to become complacent when the economy is good and stocks seem to be making new highs, month after month, year after year, for this many years. If the average investor and industry professional has never known anything else, like the turkey before Thanksgiving, they have no basis for caution. Their perception is reality, until it’s not anymore.

One other key difference that I would like to point out is the dramatic shift away from professional investment advice and into self-directed investment approaches. Since the financial services industry was deregulated, discount brokerage firms have gained massive market-share, and banks, investment banks, and brokerage firms have merged. While trading costs have certainly come down dramatically (Fidelity just announced zero cost funds and JP Morgan Chase just announced accounts with free trading), which can be viewed as a positive outcome, the consequences have been that many investors believe they don’t need any help investing. With a market that seems to reach new all-time highs every week, it can certainly seem easy to invest – a high tide raises all boats. It is easy for anyone to believe they know what they are doing, as long as the market keeps going up. But what happens when the market stops going up? Will the average investor know what to do? Will they have the discipline to stay the course with their investment strategy? Do they have an investment strategy? Do they really understand the investments they own? Have they reviewed the financial statements of the companies they have invested in so that they have a clear understanding of the specific risks inherent in that business and in the industry within which that company operates?

I am not trying to rain on anyone’s parade, and I am not claiming that the party will end tomorrow. What I am stating is that even the best parties don’t last forever. My concern is that, due to today’s market psychology, the risk of a serious correction or crash has probably never been as great. If the average investor doesn’t have a well-reasoned investment strategy, and doesn’t really understand the fundamental financial situation of the companies they have invested in, and the impact a weakening economy can have on those businesses, those investors are very likely to panic if the market starts to correct. It is easy to envision what otherwise would be a normal correction in the market to build selling momentum and accelerate into a full blown crash. Given the heights to which the markets have reached, the possibility of dramatic losses becomes clear. The domino effect of an out-sized stock market crash on the global economy is a very real and very scary outcome.

My hope is that anyone reading this will at least consider the possibility that what is perceived to be normal today is not really normal in the big picture for the stock market, and that taking some proactive steps to reduce risk in portfolios is the reasonable, prudent, best course of action.

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