Keep following the Fundamentals

It was George Soros, the trader that made a fortune betting against the British Pound in 1992, who once said “short term volatility is greatest at turning points and diminishes as a trend becomes established…” Volatility remains a key feature of today’s financial markets with investors not knowing whether to squeeze the trigger or pull the plug. The market’s daily ups and downs are not driven by fundamental factors but rather by emotion. The VIX, the Volatility Index, is the gauge most widely accepted as the best indication of investor’s risk appetite. It measures the market’s expectation of short term volatility of S&P 500 Index. Commonly referred to as the index of fear and greed, it provides scale of ‘fear’ from zero to hundred. On average, it hovers around 20 or below. This is the level where investors are considered to be relatively confident about the future. Throughout this recent credit crisis we have seen this indicator reach record heights of 80 and above.

As the pendulum of fear and greed swings, it allows the extremities to be reached as investors become too optimistic in bull markets and too pessimistic in bear markets. As the markets go through cycles so too does investor behaviour. This is illustrated by the investor psychology cycle diagram below which was produced by South African based RMB Unit Trusts.


Before trying to establish what stage of the cycle most investors find themselves in this current market situation, let’s consider each of the stages.

Contempt: According to the cycle, a bull market typically starts when a market is at a low and investors scorn stocks.

Doubt and suspicion: Investors try to decide whether what they have left should be invested in a safe haven such as a money market fund. They have burnt their fingers with stocks and often vow never to invest again.

Caution: The market then gradually starts showing signs of recovery. Most investors remain cautious, but value investors began to scoop up the bargains.

Confidence: As stock prices rise, investors’ feeling of mistrust changes to confidence and ultimately to enthusiasm. Most investors start buying their stocks at this stage.

Enthusiasm: During the enthusiasm stage, prudent investors are already starting to take profits and get out of the stock market, because they realise that the bull market is coming to an end.

Greed and conviction: Investors’ enthusiasm is followed by greed, which is often accompanied by numerous IPOs on the stock market.
Indifference: Investors look beyond unsustainably high price-earnings ratios.

Dismissal: As the market declines, investors show a lack of interest that quickly turns to dismissal.

Denial: Then they reach the denial stage where they regularly affirm their belief that the market definitely cannot fall any further.

Fear, panic and contempt: Concern starts to take a hold and fear, panic and despair soon follow. Investors again start scorning the market and once again they vow never to invest in stocks again.

In order to determine where we are in the equity market cycle, it is important to understand where investors are in this psychological cycle. I would argue that we are on the left hand side of the cycle, but where exactly is a matter of personal judgement. I believe that it is likely that investors currently fall into the area of “Doubt & Suspicion.” It is my opinion that the later cycle stages of the right hand side of this chart have already been seen back in September and October. This is when we saw mass deleveraging. Monies have now been temporarily parked on the sidelines in cash and short dated government bonds, which are offering very little in return.

This simple analysis may help with the obsession amongst investors and market commentators to call the bottom of the market. Falling energy and food prices mean that inflation is no longer a concern and all efforts can focus on promoting growth. The massive amount of monetary and fiscal stimulus that central banks and governments have provided to date is clearly designed to restore confidence as quickly as possible. The markets want to see firm evidence of these measures beginning to work fast but it will take time. We would not expect to see signs of a recovery until later next year and a return to economic growth in 2010. However in the long term we believe equity markets to be a discounting mechanism. Studies have shown that in past recessions equities have started to recover, even whilst economic news is still worsening, around six months before the official end of a recession.

Only time will tell whether we are dealing with a typical investor psychology cycle or not and what the next stage of the cycle for investors will be. However, in order to be a successful investor, it is important to distance yourself from the ‘herd’ mentality and to make objective decisions based on the fundamentals. To quote Warren Buffet “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”


John Husselbee
2nd December 2008