One sure way to get into trouble is to make investment decisions based on single economic numbers with no regard for the underlying trend. So often these days, we see markets that have rallied or reacted in anticipation of good or bad economic news. When the number is released and the reported data counter expectations, the market reacts almost instantly as it unwinds the speculative positions previously set up. Such wild action is catnip to media that thrive on volatility and excitement, but not for the investor or trader caught up in this process. The investor who is able to keep his eye on the ball and maintain perspective should actually be in a position to capitalize on such discrepancies.
Summary
It is easy to become sidestepped by events and news stories going on around us. Unexpected price fluctuations stimulate our emotions and are another source of distraction. In such situations, we must make sure that we are not incorrectly drawn into believing that the main trend has reversed. A warm day in January does not mean that spring has arrived, neither does an isolated piece of good news denote that a bear market is over. We have to learn to step back and sort out the woods from the trees.
If we are following a particular approach or methodology, whether it be a trading system or a longer term fundamental philosophy, it is also important to stick with it. Otherwise we lose our basis for making sound decisions.
Part II
THE WALL
STREET HERD
7
A New Look at
Contrary Opinion
The law of an organized, or psychological, crowd is mental unity. The individuals composing the crowd lose their conscious personality under the influence of emotion and are ready to act as one, directed by the low, crowd intelligence.
-Thomas Templeton Hoyne
The Theory of Contrary Opinion was first promulgated by Humphrey Neill, who combined his own experience and observations on the stock market with those of Charles Mackay, Gustav Le Bon, and Gabriel Tarde. Today it is popularly accepted that since the "crowd" is wrong at major market turning points, everyone wants to be a contrarian. In the world of investing, to be caught with the crowd in this day and age is the equivalent of admitting a terrible sin.
As so often happens when a concept or a theory is popularized, however, the basic idea becomes distorted. Those market participants who have not had the benefit of reading Neill and other writers on the subject do not realize that they may be on shaky ground. Neill pointed out that the crowd (i.e., the majority of investors or traders) is actually correct most of the time; it is at turning points that they get things wrong.
This last distinction is the essence of Neill's theory. Once an opinion is formed, it is imitated by the majority. This process can extend to such a degree that eventually virtually everyone agrees to its validity. As Neill put it, "When everyone thinks alike, everyone is likely to be wrong." He writes, "When masses of people succumb to an idea, they often run off at a tangent because of their emotions. When people stop to think (italics added) things through, they are very similar in their decisions" (Neill, 1980).
I have emphasized the word "think" because the practice of contrary opinion is an art and not a science. To be a true contrarian involves study, creativity, wide experience, and, above all, patience; no two market situations are ever alike. We know that history repeats, but never in exactly the same way. Hence you cannot mechanistically conclude, "I am bearish because everyone else is bullish."
Knowing when to go contrary is of primary importance. Many of us believe that the particular methodology that we are using in the market ought consistently to work for us. Unfortunately, as we discovered earlier, there is no perfect approach to investing, because the formation of a correct contrary opinion can be a difficult and at times elusive task. Even if we are able to correctly assess where the crowd stands, this knowledge can still result in frustration, because the crowd frequently moves to an extreme well ahead of an important market turning point. Many clever stock market operators correctly knew that the situation was getting out of control in 1928; they had concluded that stocks were overvalued and discounting the hereafter. They were right, but their timing was early. Unfortunately, many investors got sucked in just before the final, fateful top. Economic trends are often very slow in reversing and manias take prices not just past reasonable valuations but to ridiculous and irrational ones as well.
In a timely bearish article published in Barron's in September 1987, John Schultz wrote, "The guiding light of investment contrarianism is not that the majority view-the conventional, or received, wisdom-is always wrong. Rather, it's that majority opinion tends to solidify into a dogma while its basic premises begin to lose their original validity and so become progressively more mispriced in the marketplace."
These trends occur because investors tend to move in crowds that by nature are driven by herd instincts and the desire for instant wealth. If left to their own devices, individuals isolated from the crowds would act in a far more rational way. For example, if you saw a house that sold one year ago for $50,000 now priced at $100,000, you would judge it to be expensive. But if you knew that an identical one down the road just fetched $120,000, the price of $100,000 would seem cheap. This feeling would be especially true if you were bombarded by both friends and stockbrokers telling you of the killing they have made in real estate, along with the rosy forecasts from the media and real estate agents. Even though you might know intuitively that house prices can't continue to double forever, you would become caught up in the excitement of the moment.
Under those circumstances, it is difficult for an individual to think independently from such an established line of reasoning. As Neill put it, the art of Contrary Opinion "consists in training your mind to ruminate in directions opposite to the general public opinions and to weigh your conclusions in the light of current manifestations of human behavior." A good contrarian should not "go opposite" for its own sake, but should learn to think in reverse. By taking the reverse side, you will come out with reasons why the crowd may be wrong. If the rationale holds water, the chances are that going contrary will work.
Why is the crowd usually wrong? The answer is that when virtually everyone has taken the position the market is headed in a certain direction, there is no one left to push the trend any further. The next step is that a countertrend initiates a new trend in the opposite direction. This idea applies not only to markets, but to political, social, religious, and military trends as well.
Let's take an example of an economy that has been in recession for a long period. At such times the media typically tell of layoffs, weak car sales, bankruptcies, and other signs of hard times. The economic forecasts are almost unanimously and universally grim, and it seems as if all events are working in a selfperpetuating, downward spiral. This is the classic environment in which the majority are extremely despondent. The feeling grows that the economy will never turn up again or, at best, the recovery will be extremely weak.
And the contrarian? He would look up, not down. The contrarian would ask, "What could go right? What normally happens in desperate economic times?" The answer is that once people realize that hard times are coming, they take steps to protect themselves from disaster; hence, they cut inventories, lay off workers, pay off debts, and take other steps to economize. It is these very actions that contribute to the weak economic climate. But once these measures are taken, those businesses and individuals who made them are then in a position to experience tremendous profitability when the economy reaches a balance between demand and supply and starts to improve. As Neill puts it, "In historic financial eras, it has been significant how, when conditions were slumping that, under the pall of discouragement, economics were righting themselves underneath to the ensuing revival and recovery."
The same problem occurs in the equity, or any other market. No investors want to hold stocks if they think that prices are in for a prolonged decline. Naturally, they sell. When everyone who wants to sell has done so, there is only one directi
on in which prices can go, and that's up. The reason for this is that changes in equity prices are caused by the attitude of market participants to the emerging fundamentals. The reversal in prices is always,based on the realization by more and more people that the underlying assumptions of a weakening economy are false. Going into the bear market, many investors vow to buy stocks when interest rates begin to fall since this is a known precursor of an improving economy and stock market. By the time interest rates have peaked, equity prices have declined. So much of the economic news is so bad that the same investors either forget-or become carried away by the fear and panic enveloping them-to even think of buying stocks. The Theory of Contrary Opinion thus requires us to go against our natural instincts-a difficult task indeed.
I have only touched on a few of the elements of Contrary Opinion and will pursue the subject in greater detail later. First, however, I would like to consider two examples of manic crowd behavior to illustrate the fickleness and gullibility of crowd instincts in a more graphic way.
The Florida Land Boom
The Florida land boom began in the early 1920s when America had started to enjoy a long period of prosperity. For many years, it was the custom of wealthy Northeasterners to visit such glamorous Florida sun resorts as Miami and Palm Beach in winter. Prior to World War I, they had been joined by well-to-do midwestern farmers and northern manufacturers. In the early 1920s, this flow of visitors grew to include just about everyone.
Initially, Florida was considered a paradise. The way of life was very relaxed and visitors could soak up the sun all day while their neighbors at home were laboring in the harsh conditions of a northern winter. Land prices in Florida were substantially below the national average so it was an easy decision for many people to buy some parcels, either to settle permanently or to use as a potential second home. Naturally, as demand increased, land prices rose.
The boom started on a sound basis as prices still represented good value compared with other regions, and there was plenty of undeveloped land that could be added later to the real estate stock. Between 1923 and 1926, Florida's population grew to 1,290,350, an increase of 25%. Real estate prices grew even faster. Gradually, word spread and land prices began to escalate. In Psychology and the Stock Market, David Dreman cites the example of a lot in Miami Beach purchased for $800 that was resold several years later (in 1924) for $150,000. Another lot located near Miami was purchased for $25 in 1896 and sold in 1925 for $125,000.
As is normal in such situations, stories spread of instant wealth and rapid capital gains. After all, the economic outlook for the country as a whole was favorable and land prices were low. Developers rushed into a 100-mile strip stretching from Palm Beach to Coral Gables. Projects sprang up overnight as swamps were drained and new roads were constructed.
A major selling factor was the limited amount of American land lying in the subtropical belt. This scarcity added to the land's perceived value and carried a tremendous emotional appeal that would eventually push prices to undreamt-of levels. Scarcity is a key ingredient in giving a mania both credibility and the capability to grab the imagination.
A sure sign of a mature land boom is an unrealistic number of real estate agents. In 1925, Miami provided employment for 25,000 brokers and more than 2,000 offices. Since the entire Miami population was estimated to be 75,000, this meant that there was one broker for every three residents. The broker-resident ratio was one of the signs that prices could not continue climbing forever. Others included overburdened rail, shipping, and utility facilities. By 1926, the boom went bust and prices began their decline. Yet, the frenzy continued.
Dreman also reports that one man quadrupled his money on a beachfront lot within a week. This type of speculation in real estate is typical of a topping-out process when people often buy properties with no intention of developing, building, or living in them. Properties could be purchased with a down payment as low as 10%. Binders, a form of buyer's option, were issued that enabled the purchaser to sell the property immediately. This type of speculative activity could not continue forever. In these situations, prices eventually rise so high that more land than can reasonably be absorbed is forced on the market. A similar phenomenon occurred at the end of the Bunker-Hunt silver boom in 1980. When the price of silver reached $30 or so, individuals flooded the market with their silverware to have it melted down. The price had lost touch with reality.
However, it is extremely difficult for anyone bound up in such frenzied activity to think objectively, especially when some of the most respected financial minds in the country also fail to recognize the impending danger. Roger Babson, a leading money manager and commentator, declared the land boom to be sound. Successful speculators such as Jesse Livermore, who should have known better, also went along with the crowd. J. C. Penney and William Jennings Bryan were also willing participants. With prices rising and endorsements from respected "experts," it is little wonder that virtually everyone wanted a piece of the action. Few people at the time questioned that these so-called real estate experts had gained their reputations in fields other than real estate.
As prices rose, so did confidence. The effect of this rise in the confidence level typically showed up in the way in which loans were granted. Early on, bankers tend to be quite cautious, but as prices increase they become so confident that they approve loans less on the ability of the borrower to repay them than on their underlying equity. Of course, the procedure should work the other way because the higher prices go, the greater the likelihood that the borrower will default. Bankers also become carried away by the sheer pressure of competition. If they are unwilling to offer the money, a competitor almost certainly will. Bankers, being human, cannot help being affected by the frenzy going on around them, so they grant more and more "risk-free" loans as their outlet for participating in the boom. This psychology is not limited to the real estate area. We have seen it in the early 1980s in loans granted to what economists call less developed countries and in investments in the leveraged buyout (LBO) craze of the late 1980s.
Manias such as the Florida land boom are eventually brought to a close as rising prices bring out more and more marginal supply. Sooner or later, some of the more heavily leveraged players begin to come unstuck, thereby putting even greater supply on the market. We have to remember that people have prepared themselves only for prices to move in one direction. When they start to drop, what looked to the bankers like a comfortable 10% margin of safety evaporates overnight, as prices move below the value of outstanding mortgages. During the boom, everyone is aware of all the bullish arguments, because they have been widely advertised. This means that once the tide turns, literally no new buyers are available.
One of the characteristics of manias, especially in their final days, is that they are usually riddled with fraud. In the Florida case, this took the form of false advertisements and other sharp practices. The uncovering of such dishonesty adds fuel to the downward spiral in prices. At the culmination of the new-issues boom in the late 1960s, this took the form of Ponzi schemes associated with the IOS mutual fund company. The late 1980s LBO mania was associated with unscrupulous insider trading activity and so forth. As the bubble is blown up, there is less and less margin for error. In the case of Florida, the property market was hit with two hurricanes late in the decade.
We will draw on some more lessons and characteristics of manias later, but first we will examine another instance of crowd psychology gone mad.
The South Sea Bubble
One of the requirements of any financial mania is a revolutionary idea or concept that offers the possibilities of untold growth and quick and easy gains. We have already seen this in the example of the Florida land boom where the idea of a limited amount of American property in a subtropical region captured virtually everyone's imagination. A similar fantasy swept Britain in the early part of the eighteenth century.
At that time, it was commonly believed that one of the growth areas was trade with the South Am
erica and the South Pacific. In 1711, the South Sea Company was formed. In its charter, the company was granted exclusive rights to English trade with the Spanish colonies of South America and the South Pacific. Purchasers of the stock not only participated in a market with prospects of unlimited growth but also received a monopoly on that market. It is little wonder that the company's promoters found many willing participants.
In return for these trading rights, the South Sea Company had undertaken to pay part of the English national debt. In effect, it was buying the rights to trade. In reality, the actual rights were not as attractive as the directors made out. Spain did control a vast and wealthy territory, but the nation allowed almost no trade with foreigners. As it turned out, the company was allowed only to trade in slaves and to send just one ship per year. Even then, the profits were to be shared with Spain.
This policy impeded the company's activities, so in 1719 it again approached the English government and offered to pay off more debt as compensation for more trading rights. Holders of government debt were then offered stock in the South Sea Company. The government was happy because the debt was being paid off, and the debt holders were content because the price of the South Sea stock continued to appreciate.
Having twice successfully tried this creative financing method, the directors were then tempted to promote an exchange of the remainder of the national debt for more company stock. For this operation to become successful, it was necessary to push the price of the stock to higher and higher levels. Since the growth in profits was limited, the only way this could be achieved would be through the introduction of new concessions. The rumor mill now began to flood with stories such as Spain's willingness to give the company some major bases in Peru. Images of gold and silver flowing from South America into the company's coffers began to take hold of the imagination.
Investment Psychology Explained Page 11
