We need to know more about investor emotions.
The Stock-Return Predictor provides us the information we need to assess the risk and reward associated with a stock investment made at any of the various stock-valuation levels. That’s good stuff (thanks, John Walter Russell!). But it does us limited good unless we develop a means to implement the insights we mine with it. To implement what we have learned about how stocks work, we must learn more about how we work.
Yes, that’s right. It’s always humans who own stocks. To learn how stocks work, you must learn how humans — the sometimes funny-looking but generally goodhearted entities who buy and sell stocks — work.
It’s not a small part of the story. Investing is primarily an emotional endeavor and only secondarily a rational endeavor. Learning how humans work when they come into close contact with stocks is at least 50 percent of the job of learning what it takes to become a successful long-term stock investor.
This article is my first attempt to correlate investor emotions with the stock-valuation levels that give rise to them. The ideas reported on below are tentative ideas. I expect to revise them as we move to the next stages of The Great Safe Withdrawal Rate Debate.
Please understand that not all stock investors experience the sorts of emotions described below. I am attempting to describe the emotions that become dominant at a given valuation level. The dominant investor emotion today is anger. That doesn’t mean that you are angry, or that your friends and loved ones are angry, dear kind reader. It’s all of the other investors of today who are struggling with anger issues, okay?
You know the sort of person who shifts suddenly into your lane at 60 miles per hour and almost causes you to come face to face with your Maker before you have had time to prepare yourself properly for the meeting? That’s the sort of individual to whom I am making reference when I identify anger as the typical investor emotion of today.
In all seriousness, my sense is that most of today’s investors are more confused than angry. Many people who appear to me to possess a fine emotional balance have thanked me for the investing insights developed in our community over the past 53 months. These people are obviously not angry. They are questing.
Still, I identify the typical investor emotion of today as anger. The many investors who are unsure about how stocks work and who would like to learn more tend to be docile in the face of the intense pro-stock positions of the smaller group possessing a strong desire not to learn and not to see others learn either.
There are more in the group seeking to learn than there are in the group that fears learning (Praise the Lord!). However, because of the unwillingness of the larger group to challenge the intimidation tactics of the smaller group, it is the anger of the smaller group that dominates investing discussions of today. When 10 or 20 percent of all investors fall victim to feelings of anger, that is enough to undermine the learning efforts of all investors.
Investor Emotions (Fear and Greed) at a P/E10 Level of 6 — Indifference.
My first thought was that investors would feel a contempt for stocks when they were at a P/E10 level of 6. This is the price level at which stocks are a screaming buy, the price level at which those who in earlier days had proclaimed themselves buy-and-hold investors are filled with so much hatred of stocks that they not only have sold most of their shares but also have taken vows never again to buy into this dangerous asset class.
After thinking about it a bit, exploring some of the literature describing earlier investing eras, and playing a bit with The Stock-Return Predictor and two other investing calculators now in the development stage, I decided that that first thought was a wee bit off.
What’s the worst feeling that you can have about a former lover? Hate? No. There’s something worse than that.
Indifference is worse.
Hate is a strong feeling. Hate can be transformed into love. That doesn’t only happen in movies. Almost never do we see indifference changed into love, however. Indifference is hate turned cold.
When stocks are a screaming buy, the typical investor doesn’t pointedly reject the opportunity to buy — he ignores it. He’s been through enough. He just doesn’t care. You could tell him that the P/E10 level had dropped to 1, and you wouldn’t win his interest.
When the P/E10 level is 6, the typical investor isn’t saying that his love affair with stocks is over. He doesn’t feel a need to say it anymore. At this P/E10 level, it really is over. The romance between the investor and his once-beloved stocks is so dead that there is not even a spark of hate offering the promise of perhaps bringing it back to life.
Investor Emotions (Fear and Greed) at a P/E10 Level of 12 — Desperation, Skepticism.
When we are at a P/E10 level of 12 and are on the way down from much higher stock-valuation levels, the typical investor emotion is one of desperation. Many investors who purchased at far higher prices have already sold, so the investors who have high stock allocations at this price level are the one-time True Believers. They have a lot riding on a bet that stocks are going to come back, but they also understand at some level of consciousness that their old understanding of how stocks work is gravely flawed. This is a time for Hail Mary passes.
Stock prices don’t move in a straight line from absurdly high prices to absurdly low prices. My guess is that when we again touch a P/E10 level of 12, prices will have dropped enough that it will be possible for stocks to stage a significant rally. There is no non-emotional reason why stock prices should not be able to go up again to stay once we are down to a P/E10 of 12 (a price level a bit below the fair-value P/E10 level of 14). The economic realities cannot support a strong and long-lasting rally from today’s prices (this article was written in October 2006), but they could support a strong and long-lasting rally beginning from a P/E10 level of 12.
Why is it, then, that in earlier secular bear markets, stock valuations have always dropped much lower? My guess is that it is that desperation quality that is to blame. The True Believers are hurting emotionally when we are at a P/E10 level of 12. They have seen most of their friends get out of stocks at better price levels, and feel envy towards them for having had the sense to do so. When valuation levels rise to 14 or 16, they see an opportunity to “get whole” (in comparison to where they were at a P/E10 level of 12, but not to where they were at a P/E10 level of 26, of course). The desperation of the True Believers causes them to sell and the sales of the True Believers rob the market of the rocket fuel it needs to go higher.
Because the dominant investor emotion at this time is desperation, the drop down again doesn’t stop at the 12 mark. The prevailing investor emotions of the day cause the downfall to gain momentum that the upswing was not able to accumulate for itself.
As prices drop below a P/E10 of 12, we start to see investor emotions turn into hate, before being transformed into the indifference that applies at even lower price levels.
When the P/E10 level of 12 is touched on the way up from lower levels (rather than on the way down from higher levels) the investor emotions that dominate are emotions of skepticism. Investors are hopeful when we reach a P/E10 level of 12. Things are looking good. But they have heard so many I-Hate-Stocks-And-I-Always-Will-Hate-Stocks stories from True Believers who were burned in the fires of the last bear market that they are not quite able to feel confidence that things are as good as they look.
That helps prices advance further. So long as the dominant investor emotions are emotions of skepticism, there is little possibility of crushed hopes. So long as we do not see crushed hopes, and the stock sales that are a consequence of them, there is nowhere for stock prices to go but up. Skepticism is the most bullish of investor emotions. It’s like when you think she loves you but you are not entirely sure. You feel intensely then, don’t you? You want it to happen and you are beginning to feel some confidence that it just might.
Investor Emotions (Fear and Greed) at a P/E10 Level of 18 — Confidence, Anguish.
A P/E10 value of 18 is the happiest of P/E10 levels on the way up and the most alarming of P/E10 levels on the way down.
On the way up, investors are reassured by seeing a P/E10 level a good bit above the fair-value P/E10 level of 14. The skepticism dissipates. You move in together. But at this point we have not yet reached a stock valuation level at which further upward moves are too problematic. It is the best of all worlds for the stock investor. He is sure that stocks are a good place to put his money. And he is still to a considerable extent right to think that.
On the way down, investors are crushed to see a P/E10 value of 18. It is an ominous sign. It’s the feeling that you have at the top of a hill on a giant roller coaster. Things are chugging along so slow that for the moment it feels as if nothing is happening. You have a sick feeling in your stomach, however, about what you strongly suspect is going to begin happening soon. You haven’t experienced much of a drop yet (unless this is one of those cases where things went stark raving bonkers, as they did in the late 1990s). But you can no longer fool yourself into believing that there isn’t a big drop in your short-term future.
If investing were a rational endeavor, people would not feel anguish about being at a P/E10 level of 18. That’s a number a good bit above the fair-value number of 14, after all. But look at it from the standpoint of the investor who bought in at 44 (that’s the P/E10 level that applied in January 2000 — the highest valuation on record for the U.S. market). To that investor, a P/E10 level of 18 is an illusion-buster. Ideas that he has employed to comfort himself that valuations might not matter as much this time as they did in the past can no longer be seriously entertained once we have dropped to a P/E10 level of 18.
At this P/E10 level, the lies don’t work anymore. The honeymoon is over and it’s time to go back to working for a living again. That’s not a source of anguish for those of us who have become accustomed to the realities of life in this Valley of Tears. But the investor who has seen a P/E10 level of 44, and who let in the thought that perhaps his stock shares really were worth what the newspapers of the time were saying they were worth, is brought back down to earth with an uncompromising punch to the gut when we get to a P/E10 of 18. Seeing a P/E10 level of 18 on the way down hurts.
Investor Emotions (Fear and Greed) at a P/E10 Level of 24 — Giddiness, Anger
On the way up, a P/E10 level of 24 inspires giddiness. For obvious reasons.
This is the P/E10 level at which people come to believe that stock investing is a perpetual motion machine and an incantation that turns coal into gold and a fountain of youth all rolled into one. Buy-and-hold makes emotional sense at this valuation level. What’s not to buy? What’s not to hold?
It is the investor emotions experienced at this valuation level that cause most middle-class investors to give back on the way down a good portion of the gains they earned on the way up. If investing were a rational pursuit, people would lock in some of their gains when prices got this high. But the investor emotions experienced at this sky-high valuation level are so dreamy that the idea of selling stocks is anathema to the typical investor.
A P/E10 level of 24 is not just profitable. It is downright fun. It confirms for us our sneaky suspicion that we really are smarter than most of our peers and handsomer too. It makes us feel like we are a lot richer than we really are. These are the sorts of investor emotions that we never want to see go away.
In short, the investor emotions experienced at a P/E10 level of 24 are the most dangerous investor emotions of all.
On the downside, the investor emotions experienced at a P/E10 level of 24 are the most dark and negative of investor emotions. Hate. Anger. Fear. Injured pride. That sort of thing.
Prices are too high when we are at this price level for even the least-informed investor to convince himself that there are not dark clouds on the horizon. But the giddy feelings experienced when stocks are being sold at the highest prices at which they ever are sold are so strong that it is just too painful for the typical investor to disentangle himself from his loved one.
“Would you really do anything me for me, dear?”
“Oh, yes, I would do absolutely anything you ask of me.”
“Then do this — hold all of your shares long enough through the ride down so that you experience the feeling of losing most of what you gained during the bull market.”
“Of course, my darling. I know that you are just gifting me with another display of your warm and wonderful sense of humor. I know that nothing bad can ever happen to me now that I’ve met you. But you look so scrumptious when you talk that way that of course it would be impossible for me to say “no” to your tantalizing request. Of course I would do that for you, my jelly crumpet, and more, and with a song in my heart.”
Why do we feel passion? Because we know how hard it is to gain access to good feelings and because we know how easily we can lose access to them.
Why do investors possess the least willingness to hear about the realities of stock investing at just the time when it would do them the greatest financial good to take them into consideration? They already know the realities at some level of consciousness. And they feel an intense anger about them. There’s nothing so aggravating as knowing perfectly well something that you very much do not want to know.
You don’t want to be the one to tell people how stocks really work when stocks are being sold at absurdly high prices. When the P/E10 level is 24, the typical stock investor would rather lose a lot of dollar bills than lose the fine, fine feeling brought on by the continued enjoyment of his illusions.
And the longer we stay at a P/E10 value of 24 or thereabouts, the greater is the pain experienced at the thought of leaving those illusions behind. This is “I Heard It Through the Grapevine” time, and the typical stock investor is just about to lose his mind. The dominant investor emotion at the sky-high valuation levels is anger at anyone or anything that reminds him that love always fades (unless it is rooted in something real) and that loneliness always returns.
Today’s P/E10 level is 27.