Every morning we can see different economic analyses that, depending on the author, either claim that the bottom of the crisis has been reached, or, to the contrary, we are still very far away from the stock-market bottom.
Latest hits are the forecast that use Graham’s method and proclaim that S&P will hit bottom at between 400 and 500 points, down considerably from the current 700. If we read old news, we can see that analysts were moving the bottom from 1200, to 1000, to 900 etc. After each big fall, the bottom moved lower.
How can well educated economists be so wrong? It is a fact that all economic theories and models big explanatory powers after the event, when the models are corrected and it is plain for all to “foresee” such an event, but this was not yet visible from the theory and model before the event.
Economics as a science is based on premise that there are certain economic laws that are stable and unchangeable. Let me just mention two: All individuals are always acting rationally, so emotions, such as fear, panic, uneasiness, happiness or euphoria have absolutely no impact on their investment decisions. The second premise to mention is that all individuals have access to perfect and full information, so they can make truly rational investment decisions.
On average, in normal circumstances those premises are correct, since statistically and in the long term there is around one half of people that are too optimistic, and around one half are too pessimistic, so those extremes are cancelled out and the optimal remains.
When the circumstances are not normal, such as in the case of great euphoria during the boom, or great panic during the crash, those two premises fail miserably, as there is either too many optimists or pessimists respectively. This then biases average investment decision to either too optimistic or too pessimistic.
This is the main reason that economic models in the current format can not properly forecast what will happen in exceptional (not normal) circumstances. The models do not allow for the market sentiment, which does not show in the case of individual investor, but it becomes painfully obvious one you aggregate the actions of those individuals (when everybody is euphorically buying or panically selling, no matter what the price).
The idea of market sentiment, or animal spirits in the market, is far from new, and was already mentioned by J.M. Keynes. Unfortunately, due to the complications that it brings to mathematical formulae, it has never caught up, despite some serious efforts in the last two decades.
Very good analysis of market sentiments was made recently by Prof. Paul de Grauwe from the University of Leuwen in Belgium. You can find the analysis at the following URL: http://www.ems.bbk.ac.uk/research/Seminar_info/DeGrauwe
In the analysis he claims that the equilibrium of pessimists and optimists is only coincidental and that the market reaction to exactly the same impulse is vastly different if optimists or pessimists prevail. As an example we can take the news that company A has lowered the dividend. Optimists would believe that the company sees more internal opportunities for growth and would therefore buy the stock, while pessimists would believe that the company is going for broke.
From this we can see that the market bottom is not where the technical indicators show it to be, but rather when a majority of people believes that a stock is a good investment at the current price.
There is one more problem with the stock market bottom. We can only call it such when sufficient amount of time has passed and the price has moved significantly higher.
We all remember the growth of stocks from September to December 2008, when everybody was convinced that the worst is already behind us. Then, we had the request for help from Citibank, investors got scared and we have seen another big fall.
When to buy?
To buy, or not to buy, that is the question. The basic theorem of investing says that you need to buy low and sell high. Whoever is waiting for bottom will miss the chance, since before we can seriously consider it as a bottom, the prices will be at least 30% higher. This is the reason why investors have to believe themselves and their analysis, because they are the only ones that know their capacities to invest and their needs.
If investors see that the stock is a good buy at 30, it is better to buy it at 30. If the stock then falls to 25, before rebounding to 50, they can be happy with the profit, and they should know that if they were waiting for bottom, they would not buy the stock at 25, but rather would still be waiting for it to reach it, and thus miss the chance.
An investment for which investor can not set an appropriate price should not be made. The most important thing to know is that we believe in ourselves and our abilities, as if those were not present, we would not have the money to invest.
This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading SlovenianInvestment Magazine KAPITAL, on 16.03.2009. Original article is available at the following URL: http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6569
