The vast array of information available today should allow consumers and investors consistently to make rational decisions, but as the rapidly developing field of behavioral economics recognizes, emotions influence nearly every economic choice we make.
Buying a car is a simple example of how emotion can affect a decision. Numerous sources offer vehicle buyers data on every aspect of a car or truck including detailed breakdowns of cost. Yet, often buyers stray from their intended purchase, as the look, smell, and gadgets in a new vehicle overwhelm all the information about the originally intended purchase, which is why wise salespeople utilize an old cliché: Sell the sizzle, not the steak.
The “wealth effect” can occur when buying a vehicle or any large purchase.The wealthier you feel, the more likely you are to make a major purchase.
Several widely reported measures attempt to determine how we collectively feel about the economy. Through a monthly household survey, the Conference Board’s Consumers Confidence Index attempts to quantify consumers' opinions on current conditions and future expectations for the economy. Similarly, the monthly University of Michigan Consumer Sentiment Index compiles results from 500 telephone interviews into an index that reflects the consensus of the interviews.
Investors often refer to the Investors Intelligence and the American Association of Individual Investors (AAII) for their weekly surveys that ask respondents whether they have a bullish, bearish or neutral market view---in other words, how do they feel about the equity market.
These economic and stock market sentiment measures share an unusual characteristic. In a contrarian context, they often are most useful at extremes.
Consumer Confidence Index hit its record low in January 2009. Negative GDP growth in the midst of a recession, coupled with the usually stalwart consumer cutting back, led personal consumption expenditures to drop. By the fourth quarter of 2009, however, GDP growth had rebounded to a 4.5% seasonally adjusted annual rate (SAAR).
Assessing the stock market is no different. Some people suggest that the market represents the collective intelligence of all participants. If so, then it also has the collective sentiment of the participants. Evaluating the market personality, however, can be challenging.
Feeling too good or too bad can be problematic. Through many decades, extreme levels of bullish or bearish market sentiment has been inversely correlated to subsequent stock market movement.
January 6, 2001, marked the all-time record high in the bullish percentage of the AAII survey. The equity market then embarked on a slide that by a year and eight months later generated a 31.12% loss in the index.
Conversely, reflecting extreme pessimism, November 16, 1990, marked the all-time AAII bullish percent low at 12%. One year later, the S&P 500 was up 20.65%. Four days before the Christmas Eve drop in 2018, the bullish percent was only 24.86% with the S&P 500 at 2467.42. By New Year’s Day 2020, the S&P 500 was 30.94% higher.
Positive or negative sentiment can remain for extended periods. After the Great Recession in 2008-2009, several years passed before the common refrain, “I do not want to revisit 2008 again” receded, but during this time of continuingly negative sentiment, the equity market was well on its way to produce one of the longest bull markets on record.
Numerous factors that often evolve over time affect how you feel about most things. In an investment reference, factors as simple as the name of a company, where it is located, its industry or one bad experience with a product or service can mold your feelings.
A poor short-term investment result can provide a good example of how emotions sway actions.
If investors buy a stock at $50 a share that over weeks or months slides to $35, disappointment can lead to misguided actions. If the stock begins to recover, investors fearful of taking a loss often look to the $50 breakeven point as a target - so much that if the stock price gets to or near $50, “get me out even” often is the overwhelming psychology without regard to the possibility that the recovery could extend substantially further. This mentality is so well-documented that it has become part of technical analysis.
Often, a financial advisor’s most important job is to protect clients from themselves. This is not to suggest that financial advisors have all the answers. They, however, can guide investors away from emotions that lead to bad decisions or ones that run totally counter to a well-constructed financial plan.
In the last 50 years, the average annual price-only gain for the S&P 500 has been 8.35% with an average gain for all decades of 9.1%. On the occasions when negative feelings become overwhelming, these facts that should help dispel extreme angst.
As always, however, paying attention to how “Mr. Market” feels is worthwhile.
Past performance is no guarantee of future performance and future returns are not guaranteed. There are risks associated with investing in stocks such as a loss of original capital or a decrease in the value of your investment. This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis.