Bull markets are born on pessimism, grow 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.”
– Sir John Templeton
In last month’s article, we focused on “being observant” as one of the great qualities to adopt for anyone who wants to become a great investor. This month we focus on a similar, but slightly different quality…Great Investors have a Healthy Memory
There is great wisdom in John Templeton’s quote above, as it recognizes investor sentiment as an enormously important factor in stock market cycles. In our view, long term market cycles are largely dictated by “the mood of the crowd”, and great investors are well served to pay attention to investor sentiment. To paraphrase Templeton, we have a belief that no great, multi-year bull market can begin unless the majority of the investing public is terrified of losing money in stocks, and that their equity holdings can tank at any moment, and for any reason. Alternatively, no terrible bear market can occur unless investors are complacent, and convinced that stocks can’t go down at all, and that their greatest risk in their stock portfolios is that someone else is earning bigger returns than they are.
Unfortunately for the impatient and short sighted, such “long term market cycles” we are talking about here tend to unfold over significant periods of time, usually something like 10-15 years. To become a great investor, it helps to not only intellectually observe these historical inflection points, but to have a healthy adult memory of how they felt. It is one thing to intellectually understand that the stock market had a terribly bearish year in 2008, but it is a whole different level of experience to remember how it actually felt on the day that Lehman Brothers declared bankruptcy, and it seemed as if the entire fabric of the world economic and financial world was being torn to shreds. Only those who lived it and remember how it felt, can truly have the rational, and unemotional understanding necessary to take advantage the next time it comes around!
Euphoria: What does it feel like?
As Sir John Templeton observed, the great Bull Markets in history have all been slaughtered in a glorious melt-up of optimistic euphoria, as investors’ rosy views of the future don’t materialize, leading to widespread disappointment. Knowing this, the wise investor must watch out for signs of euphoria in the market, and be careful when those signs are evident. But how to do this? What does euphoria feel like?
My own personal experience of euphoria can be defined by the story of a local company called the Internet Capital Group. In August of 1999, at the height of the “Dot Com” craze, Internet Capital launched their Initial Public Offering at a price of $12. By the end of the trading day, the company’s stock closed at a price of just over $24, for a handsome profit of over 100% in one single day. By the end of the year 1999, the company’s stock had risen to a price of $212. Yes, you read that right: investors who were lucky enough to get in on the Initial Public Offering of this company earned over 15 times their money in less than 4 months!
It may seem that the late 1990’s were a wonderful time to be a financial advisor – after all, all one had to do was to load up client portfolios with any company with a “Dot Com” in the title and watch the profits multiply – it was actually quite a challenging time to be an investment professional. Because diversification and asset allocation are important elements of the job description of a professional advisor, many a financial advisor was fired during those heady days because they refused to “load up” their client portfolios with 100% in technology and “Dot Com” stocks. For me, the reason that Internet Capital stock stands out so clearly in my mind among the hundreds of “Dot Com” companies whose stock prices catapulted into the stratosphere, is that ICGE happened to be a local company, which many of my clients and friends knew quite well. As a result, it was difficult to explain to clients why we hadn’t dedicated a huge portion of their portfolio allocations to a local company that so clearly was making people rich.
Euphoria is owning an investment which multiplies in value 15 times in 4 months. Euphoria is when people fear missing out on gains more than losing money. Investors experiencing euphoria believe firmly that the risk of losing money in stocks is exactly zero, and that the single and solitary risk to any investment program is that someone else somewhere is making more money than you are. Investors are consumed by the need to scramble at all costs, to own the same thing that is getting everyone else rich, and fast, before the party is over. People expect that stock prices will appreciate at a rate of 20%, 30%, 50% per year, indefinitely into the future.
And then, just like that, the Bull dies of a massive cardiac fit of disappointment.
The Other Side of the Coin: Fear
Templeton’s famous advice also reminds us that all of the great equity bull markets of all time have been born when pessimism is at a peak, or in the words of another famous investor, Baron Rothschild, “The time to buy is when there is blood in the streets”. What does this kind of pessimism feel like?
Many of us recall that 2008 was a terrible year for investment markets, but the truly great investors will never forget how they felt during the terrifying days of the fall of 2008. The events of September and October of that year are painful to recount: Bear Stearns and Lehman Brothers, both multigenerational fixtures of the global financial landscape, went bankrupt overnight. Several other important institutions such as Merrill Lynch, Morgan Stanley, and Goldman Sachs, were hanging by a thread. A significant Money Market fund “broke the buck”, and traded for a price below $1, which was unheard of in the Money Markets. Global stock markets cascaded downward in a sharp decline not seen since the Great Depression.
Among all of these, my own personal experience of sheer terror came on September 29th, 2008, which was the day the House of Representatives voted on the proposed “Troubled Asset Relief Program”, or TARP for short. The TARP program had been proposed as the savior of the markets and global economy: A $700 Billion governmental fund which was to be established to purchase “troubled assets”, and thereby stabilize the credit markets. The promoters of TARP had convinced most market participants that it was the only way to rescue the markets and restore order, but it was also not without opposition among some politicians in Washington who did not agree that the government should “bail out” the markets.
On September 29th, the House of Representatives held a vote to approve the TARP program, in a pivotal moment for markets everywhere. I will never forget watching the vote count unfold with one eye, while my other eye was on my computer. As the voting began, and it became clear that the TARP would not be approved by Congress, I can recall vividly that the Dow Jones Industrial Average fell by 500 points in the 20 minutes it took to conduct the vote, on the way to a 740 point drop for the day. Indeed, investors seemed to believe that all was lost, and were “throwing in the towel”.
In retrospect, 2008 was not a bad year because investment markets were down. The Dow Jones declined by 33.8% that year, which was an unpleasant result, but more trying was that most Americans felt that the economic world was literally coming to an end…that the markets, the economy, the world are doomed, and nothing can save us. Equity prices will never rise again, and the only thing that matters is the safety of capital at all costs.
And just like that, a new Baby Bull emerges.
The Cycle of Sentiment
As this diagram shows, investor sentiment has many “stopping points” on the way from Euphoria to Despondency and Depression, and back again. This mental and emotional process can take a long time for both individual investors and the collective market as a whole.
So where are we now? What conclusions can we draw about the current state of investor sentiment, and how might those conclusions be helpful in making investing decisions today?
The events of 2008 are behind us, and nobody would argue that market participants are feeling despondent or depressed today. However, we are also nowhere near the euphoric sentiment of 1999 when 20% returns per year every year seemed to be a God given right, and investors were willing to throw their life’s savings into any company with a “Dot Com” in the name.
Most likely, we are somewhere in between.
While investors are nowhere close to the level of pessimism experienced in 2008, most investors are still quite worried and waiting for “the other shoe to drop”. Indeed, the current market uptrend has been called “The Most Hated Bull Market in History”, and it seems that investors everywhere remain skeptical of the current Bull Market. Most investors appear more likely to express feelings of fear than greed today.
I found the attached chart from the American Association of Independent Investors to be quite interesting. AAII is famous for their regular surveys of investor sentiment, and this chart depicts the history of this survey through late September of 2016. As the chart shows, the long term average Bullish sentiment among investors is 38.4%. In 1999 it was 49.4%, just about 10% above the average, and today it is 28%, just about 10% below the long term average. I found this symmetry to be interesting. Bullish sentiment is lower today than during the 2008-2009 Great Recession!
Having a Plan
The very best investors have a disciplined approach to making portfolio decisions, and always stick to their plan, no matter what the rest of the world is doing. They are able to live through the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.
No predictions. No witch doctor investment sorcery or magic investing formulas. No “Black Boxes”. Just hard work, patience and discipline.