Investor lessons from taking the temperature of markets

Understanding prevailing investor psychology is key to long-term investment returns.

How can an investor make useful observations regarding the status of the markets? Most of the time, markets are near the middle ground — perhaps a little high or a little low, but not so extreme as to permit dependable conclusions.

Investors’ records of success with calls in markets such as these are poor. Even if they are right about asset prices being out of line with fundamental valuations, it is very easy for something that is a little overpriced to go on to become demonstrably more so, and then to turn into a raging bubble, and vice versa.

However, once in a while, markets go so high or so low that the argument for action is compelling and the probability of being right is high. When markets are at these extremes, the key to generating superior future investment returns lies in understanding what is responsible for the current conditions.

Everyone can study economics, finance and accounting and learn how the markets are supposed to work. But superior investment results come from exploiting the differences between how things are supposed to work and how they actually do in the real world.

To do that, the essential inputs are not economic data or financial statement analysis. The key lies in understanding prevailing investor psychology, or what I like to call “taking the temperature of the market”. Here is what I consider the most essential components:

• Investors should learn to recognise market patterns. Study market history in order to better understand the implications of today’s events. Ironically, investor psychology and market cycles — which both seem flighty and unpredictable in the short term — fluctuate in ways that have more for regular patterns when viewed over the long term (though with highly variable causality, timing, and amplitude).
• Understand that cycles stem from excesses and corrections. I define cycles not as a series of up and down movements, each of which regularly precedes the next, but rather as a series of events, each of which causes the next. I think economies, investor psychology and markets eventually become too positive or too negative, and afterwards they eventually swing back towards moderation (and then usually towards excess in the opposite direction). Thus, a strong movement in one direction is more likely to be followed by a correction in the opposite direction than by a trend that “grows to the sky”.
• Watch for moments when most people are so optimistic that they think things can only get better, an expression that usually serves to justify the dangerous view that “there’s no price too high”. Likewise, recognise when people are so depressed that they conclude things can only get worse, as this often means they think a sale at any price is a good sale. When the herd’s thinking is either Pollyanna-ish or apocalyptic, the odds increase that the current price level and direction are unsustainable.
• Remember that in extreme times, the secret to making money lies in contrarianism, not conformity. When emotional investors take an extreme view of an asset’s future and, as a result, take the price to unjustified levels, the “easy money” is usually made by doing the opposite.

This is, however, very different from simply diverging from the consensus all the time. Most of the time, the consensus is as close to right as most individuals can get. So to be successful at contrarianism, you have to understand (a) what the herd is doing, (b) why it is doing it, (c) what is wrong with it, and (d) what should be done instead.

• Bear in mind that much of what happens in economies and markets does not result from a mechanical process, but from the to and fro of investors’ emotions. Take note of the swings and capitalise whenever possible.
• Resist your own emotionality. Stand apart from the crowd and its psychology; do not join in!
• Be on the lookout for illogical propositions. When you come across a widely accepted proposition that does not make sense or one you find too good to be true (or too bad to be true), take appropriate action.

How should investors think about market timing? I believe every investor should operate most of the time in their normal risk posture — the balance between aggressiveness and defensiveness that is right for them. I believe investors should approach making market calls with great humility, diverging from their neutral assumptions about the future and their normal positioning only when circumstances leave them no other choice.