Psychology is the great underappreciated variable in investing and trading that magnifies the underlying fundamentals and consequently exacerbates price trends. Perhaps the following John Templeton quote states it best: “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
At Berkshire Hathaway’s recent investor conference, Warren Buffet criticized Wall Street for turning the capital markets into a “gambling parlor” by encouraging risky behavior among investors. Between the gamification of trading call options to the creation of increasingly speculative cryptocurrencies it’s hard to argue with him. Even with the S&P 500 Index off by more than 15% on the year and the NASDAQ Composite lower by more than 25%, speculative fever remains. Meme stocks Gamestop and AMC both opened higher by nearly 30% Thursday as traders crowd into positions looking for quick profits. This is not the behavior seen near market bottoms.
In bull markets, any negative news is shrugged off as stocks charge higher and more investors are lured into the opportunity to make money. When the bull market is obvious to everyone, the gains that came quickly and easily begin to falter. In addition, there are no additional marginal buyers to invest, and the market tops. All the capital that can be invested already has and therefore the fuel of the uptrend is depleted.
Early in the market topping process, the most recent investors see an opportunity in the selloff. As the selloff intensifies, psychology shifts, and investors now hope to earn modest returns on their investments. The psychological shift creates sustained selling pressure above the current market levels, so any rally is sold. Finally, the selling intensifies, and investors become focused on the return of their principal as opposed to the return on their principle. The cycle becomes self-reinforcing on the downside until fear grips investors and a final capitulation is reached.
I began my career at Salomon Smith Barney in 1999 and the firm’s head technical analyst Louise Yamada heavily influenced my understanding of market cycles. She would remind all who would listen at the time that “the bigger the top, the bigger the drop.” Attempting to predict this cycle’s eventual low is futile as it will be heavily driven by investor psychology and only evident in hindsight. A 13-year bull market in stocks propelled by negative real interest rates, unprecedented Covid stimulus, and the enduring belief that buying the dip is a sure way to growing wealth will take time to unwind.