Special Report by Jim Shepherd

The Psychology of the Markets

   One of the most difficult things for most investors to understand is that in the investment markets, often the opposite of what you feel is actually the reality. This means that when everyone is certain of a particular outcome, the odds of it happening are remote. Now, this is not the same thing as ‘manifest destiny’ or some sort of ‘positive thinking’ that produces a desired outcome. No, here we are speaking about why investment markets ultimately cannot exceed their borders.

   You probably have already experienced the consequences of what happens when everyone is convinced that the stock market will rise forever. Recent history has shown that ultimately it is not possible for the stock market to rise beyond certain limits, although those limits were pushed to new heights in the recent example. But you no doubt have realized that even though at the time many were making what seemed to be reasonable arguments as to why the market could continue to rise, those same arguments are now widely seen as unrealistic. So why, you may ask, did so many intelligent investors and advisors get caught in the same trap?

   It seems as though every generation has a particular phase where nearly everyone becomes ‘expert’ in some investment area. In the 1920’s, almost everyone had some stake in the booming stock market. Speculation became commonplace, replacing investing as the modus operandi. Now, I have nothing against speculation per se—there have been many times that we have successfully speculated in various investment areas. However, when most of the investing public becomes speculators, it creates a situation that cannot last for long. If you think about this carefully, you will see why this is the case.

   Speculation, by definition, involves taking a position that will benefit from a certain outcome. It is not concerned, necessarily, with underlying value, nor is it a view that tries to forecast the future for a particular industry or company purely beyond its short-term price action. You see, when investors become speculators they are purchasing a stock with the sole purpose of selling it to someone else at a higher price. Now, this may seem obvious at first glance, but it isn’t. Of course everyone wants to make a profit on the stocks they buy but there is a big difference between speculation and investing. The speculator doesn’t care about the inherent value of the stock—he or she only cares about whether or not they think it will go up in price as more and more speculators accumulate the stock. The investor, on the other hand, looks at the logical value that may accrue over time as the particular stock price is affected by the ongoing business, the industry, economy and so on. When speculation becomes rampant, as we saw in late 1999 in the stock market, it creates a situation that is impossible to perpetuate. A good way of understanding this saturation point is to think of rampant speculation in terms of a chain letter or similar pyramid scheme.

   Have you ever received a letter promising that if you send a certain amount of money to individuals on a list eventually you would be the one receiving the money from thousands of future participants in the pyramid. Of course, if you took the time to analyze the reality of this approach, you would realize that in order for the chain to continue to you, nearly everyone in the country would have to be involved. That is why these schemes always break down—since there is no inherent value in what is being sold, there is a requirement to continually bring in others in order to continue the process. Eventually, the whole thing breaks down and those that got in too late get left holding the bag. The same thing happened with the stock market in the late 1990’s: stocks became things to trade and were no longer viewed as ownership of a corporation for the purpose of participating in the ongoing success of the corporation. If that were not the case, how else could you explain why reasonable people were willing to pay hundreds of dollars per share for the stock in companies that had never earned a profit and were likely never to do so?

   Now, many have talked about trying to identify the point at which this rampant speculation is about to break down. Hundreds of books have been written on the subject of contrarian investing. But you should realize that most of the authors of this type of work would have had you miss most of the opportunities that were available in the last major bull market. No, it is not enough to simply grit your teeth and declare that you will always do the opposite of everyone else and that is how you will make money. The landscape is littered with the reputations of many of the perma-bears (those that for years declared the stock market was overvalued and hid in cash, missing the greatest bull market in history). Eventually, they were right, but in my opinion being right too early is the same thing as being wrong. So, merely being a contrarian is not the answer either, though is does play a role.

   What then do we do to determine when the market has gone too far and is about to bust? Well, remember that a market can always swing further than most expect. The pendulum swings both ways and a market that has been vastly overvalued will typically swing to extreme under valuation before a new opportunity to invest in stocks presents itself. That is because human nature is underlying the functioning of the stock market. You see, before a market will reach a point where it is about to totally change direction, the vast majority of those involved must believe that the trend in place will continue. In other words, we must reach that point where most believe that things will never go down. That is what happened in late 1999—almost everyone thought that they were destined to become millionaires in the stock market so long as they continued to buy stocks. As with the chain letter, though, those that came in last were destined to be disappointed. The market reached a point where it simply could not go higher. The liquidity necessary for more and more investors to keep pushing more and more stocks higher and higher just wasn’t available. The market had reached the point where, since everyone was buying stocks for the sole purpose of selling them to someone else at a higher price in the future, there wasn’t a sufficient number of willing participants with the required capital to drive things any higher. Valuations and expectations had reached preposterous levels. For example, one prominent Internet supplier at that time was forecast to be worth more in five years time than the GDP of the United States! This idea was ridiculous, and yet it was accepted by many as fact in the heydays of the late 1990’s.

   So, is there any way to determine when a market is about to shift from bullish to bearish and then back to bullish again? The answer is an emphatic YES! The model I created in the 1980’s has been proven over many years of real time and historical analysis to show that predicting when a market is about to make a dramatic change in direction is possible. The many indicators that are components in the model give me clear warning as to when this is about to occur. For example, the model kept us in stocks until late 1999, and then issued a clear sell signal. While most were expecting the market to continue higher ad infinitum, we sold out of stocks and went into another investment area that has profited handsomely while stocks were pummeled over the last couple of years. And, before this new bear market has run its course, you should expect to see similar extremes of emotion as it reaches the bottom as you did when the bull market reached its peak.

   You see, when it comes to human nature, nothing much changes. Although technology changes and the way we invest may change, human nature does not. Investors are people and they will react the same as people have always reacted in the past. When we reach extremes—either of optimism or pessimism—you can be assured that things are about to make a 180-degree turn. That is what the model has so effectively been able to measure over time: the point at which the market is about to change direction completely. When we will see the end of this current bear market is still in question. We will have to wait for the direction of the model to be sure that the bear market is over and a new bull market has emerged. Before that happens, however, we can expect more fireworks ahead. As I previously said, the market always swings to extremes, and this is primarily because of the emotions of all those investors that are participating in the market. So until the vast majority of investors become convinced that stocks will never recover, you can be pretty confident that the worst is still not over. In short, until you see the emergence of generally the opposite psychology that was evident at the very end of the bull market, you will not see the end of this current bear market. But, as I said, the best way to know this for sure is to rely on the guide of the model, which measures all of the underlying forces that go into the creation of either type of environment.

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