The Psychology of Autumn

Adam Hamilton    August 31, 2001    4048 Words


As Labor Day weekend arrives in the United States and the Europeans return home from their month-long tours of duty on the gorgeous beaches of the Mediterranean, this wonderful season of summer unofficially draws to a close.  The long and sunny days, the lovely evenings, the short work weeks, and the fun vacations and day trips all migrate back to their winter caves to hibernate through the long, cold snowy season until they are once again rekindled in the second summer of the new millennium.


From an investing perspective, the fading summer of 2001 was certainly surreal and baffling. 


The US equity markets spurned their customary summer rally and even refused to hold the status quo ante by lazily drifting lower in the doldrums.  The relentless super-bear that is mauling the States continues to slash unabated with his wicked and razor-sharp claws.  While the non-conformist equity shorts had a very profitable summer barbecuing the chunks of long investor flesh the great bear ripped loose, the legions of equity longs continued to be slaughtered on the NASDAQ altar as they bravely hung on to their beloved burning stocks.  Many longs resigned themselves to march to their deaths as martyrs as they stubbornly clung to the tattered shreds of the once sacred New Era mythology.


Lest the equity longs feel too bad, it was a tough summer in key commodity arenas as well.  The oil bulls had a fantastic setup leading into the summer, with that wily, old fun-loving-criminal despot of Iraq Saddam Hussein slamming shut his huge 2m barrels per day of crude oil exports for a month in order to rattle his saber at the imperialistic British and American sanctions and air hegemony over Iraq.  Even with the pervasive economic slowdown in the States, global demand for crude oil was running higher than in 2000 and it looked like a great trading opportunity.  Alas, however, even Saddam and high demand together could not convince traders to buy into the oil market.  While oil certainly did not crash it drifted along in the doldrums and investors mercilessly abandoned oil stocks as if they were swarming with the deadly Ebola Zaire virus.


Gold once again flirted with its biggest fans this summer but ultimately denied any sustainable rally.  After an exciting spike in May on the heels of the historic Gold Anti-Trust Action Committee’s ( Summit in South Africa, gold again had its knees chopped out from under it for the umpteenth time since 1995.  It has been a tough six or seven years for gold investors, and this summer unfortunately proved to be no exception for the lethargic ancient metal of kings. 


Every cloud does have a “golden” lining, however, and the lack of action in gold was partially offset by the incredible progress and stunning discoveries unearthed by GATA this summer.  The fearless Team GATA continues to dig through the dusty archives of arcane official government records and is still finding increasing evidence of a massive and concerted effort by the Clinton Administration to control the price of gold as a key strategic thrust of its much ballyhooed strong dollar policy.  In the upcoming September issue of Zeal Intelligence, which will be published on September 4, we will discuss and analyze the latest exciting discoveries in the ever more intriguing world of gold for our highly-valued clients.


Overall, the summer of 2001 was obviously quite a season and certainly one of the more unique market summers in modern financial history.


As summer fades and autumn relentlessly approaches like a juggernaut, a discussion of market psychology could prove profitable.  As investing is a highly emotional endeavor, the general state of mind of investors is an incredibly important determinant of future market direction.  The customary psychology of autumn could mix with the bleeding US equity markets in the coming months to breed stellar trading opportunities for the prudent contrarian.


Noah Webster’s namesake unabridged dictionary defines psychology as “the science of the mind or mental states” and “the science of human behavior”.  While a thorough understanding of crucial hard empirical concepts like valuation and cashflow is absolutely essential for an investor to master the markets, market psychology is not far behind in being a force to be reckoned with that must be understood and constantly monitored.  Market psychology is a critical component of investing and speculating because the markets are continuously moved by the aggregate decisions of millions of independent investors, most of which are highly emotional about investing.


Perhaps the enormously powerful forces of investor emotion can best be understood by examining historical booms and busts.  Whether one investigates the Tulipomania in Holland in the 1630s, the Mississippi Scheme in France in the 1720s, the South Sea Bubble across the Channel in England also in the 1720s, the Railroad Bubble in England in the middle of the nineteenth century, the Great Stock Bubble in the United States in 1929, or the famous Japanese Bubble of 1989, the vast importance of investor emotion becomes readily apparent.  Without a working understanding of investor emotion and market psychology it can be very dangerous to trade in our modern chaotic markets.


One pervasive thread that binds all these diverse bubbles together through the fabric of time is their common investor emotions and market psychology.  It soon becomes evident upon careful examination that the state of mind of a Dutch tulip trader in 1636 was no different than the state of mind of an American day trader in 1999.  Both speculators completely lost sight of reality and were whisked up in the whirlwinds of speculative manias.  These speculative manias themselves were the products of a timeless human emotion, naked greed.  The raw greed of participants in each historical market bubble blinded their minds and intellect like a blizzard of metallic chaff obscuring a fighter jet from radar.


During speculative manias the normal rational human mind is bent into an eventually lethal downward spiraling deathtrap of a focus on greed.  Some of the historical examples of the degree of the subversion of logic to greed are extraordinary.  Near the climax of the legendary Tulip Mania of Holland in 1637, a single rare tulip bulb (yes, the common flower) commanded utterly ludicrous prices.  One particularly superb sample, a single tulip bulb, fetched 27 TONS of wheat, 50 tons of rye, 4 oxen, 8 pigs, 12 sheep, 3 tons of cheese, and a silver beaker!  Talk about irrational exuberance!


From our modern “enlightened” vantage point we can smugly look back and shake our heads at the silly Dutch culture of the 17th century that focused its energies and greed on the simple tulip, but the behavior of our otherwise intelligent peers during the Internet Bubble of 2000 was fundamentally no different.  Rather than paying vast amounts for a tulip bulb, modern greed zeroed in like a heat-seeking missile on something with even less inherent worth than a tulip bulb, paper.  Otherwise rational investors purchased pieces of paper (stock certificates) for hundreds or even more than a thousand dollars per share that represented an infinitesimal ownership stake in companies that had never made a single penny of profits in their entire histories.  Greed once again clouded the better judgment of usually rational investors during the Internet Bubble as it has so many times before in human history.


Raw, naked greed ultimately spawns booms and speculative manias.  Every few generations or so, like a herd of lemmings suddenly all sprinting over a cliff for their exciting three second freefall into the lethal boiling sea, investors collectively check their brains at the door and get caught up in a spectacular speculative mania.


Not surprisingly, the burst and bust stages that always follow speculative manias are also driven by investor emotion and market psychology.  Some seemingly insignificant event causes an initial sharp break from the nosebleed heights of a mania market.  This event is commonly known as a crash.  After the initial crash event, the participants in the bubble aggressively rationalize the crash as a mere temporary bump in the road and a bounce rally ensues.  After the bounce rally burns out, a long, grinding bear market roars to life as investors slowly began being overcome by the emotion of fear and selling their rapidly depreciating holdings.  Cold, black fear replaces greed and, one by one, investors give up hope and sell out of the market.  Finally, at the ultimate bottom, there is no one else left to sell and valuations plunge far below historical norms.


Greed and fear have always driven market overvaluation and market undervaluation and they always will.  As the emotional human heart never changes, investors will always be buffeted by greed and fear and markets will be moved dramatically when greed or fear captures the collective imagination and binds up the rational minds of the investing population.


While these stunning examples of greed and fear through booms and busts are definitely the extremes, they are very useful to illustrate the behavior of more ordinary markets as well.  Once again, overvaluation of a stock or market relative to the cashflow it can spin off for its owners is caused by greed.  Undervaluation is caused by fear.  The ultimate goal of all investors, of course, is to buy low and sell high.  This holy grail of investing can be attained by analyzing investor emotion and market psychology and attempting to buy when investors are scared and sell when they are euphoric.  The legendary investor Warren Buffet summed up this whole concept beautifully in his fabulous quote, “Be brave when others are afraid, and afraid when others are brave.”


As we plunge into this autumn, market psychology and investor emotion are very important.  When we consider investor emotion coupled with current market valuations, the probable course of the US equity markets this autumn becomes much more clear.  We will begin with the question of valuation, continue with the question of market psychology, briefly discuss the general psychology of autumn, and end with the most probable course of action for the US equity markets this autumn.


By analyzing valuation, it is possible to gain a quick perspective on whether investor emotions are still high up on the greed end of the market psychology scale or whether they have plunged down into fear.  If greed is still ruling the roost, we would expect valuations to be higher than historical norms.  In the great greed phases of market history investors ignore fundamentals and bid up stock prices to unsustainable heights.  If fear is the popular emotion of the moment, we would expect to see valuations lower than historical norms.  In the fear phases of market history investors aggressively liquidate most of their equity holdings and avoid the equity markets like the plague.


For a historical normal valuation level around which we can define over- or undervaluation, we continually focus on the many century old average valuation of equity markets as defined by the revered price earnings ratio.  The normal historical equity market valuation corresponds to a P/E ratio of roughly 13.5.  If it has a higher P/E ratio a stock or market is overvalued, and if it has a lower P/E ratio a stock or market is undervalued.  For a deeper discussion on P/E ratios and why they are probably the most important proxy for valuation, please see our earlier essay “Plummeting Profits”.


Using market capitalization weighted average P/E ratios we can quickly distill a vast amount of market information down into single comprehensive numbers that indicate broad equity index overvaluation or undervaluation.  As this essay is being penned before the final market close of August 2001, our final August equity index P/E ratio calculations have not yet been completed and these numbers deployed here are all from the end of July.  The latest August numbers will be published in the new September issue of Zeal Intelligence and are unlikely to be significantly different from July’s calculations.


The venerable S&P 500, representing the 500 best and biggest companies in America, sported a market capitalization weighted average (MCWA) P/E ratio of 33.1 at the end of July.  This is enormously overvalued and still way into the extreme bubble valuation range.  By this measure, the S&P 500 could hemorrhage another 50% and still be overvalued on a fundamental basis.


The elite blue chip Dow 30 stocks had a MCWA P/E ratio of 29.9 at the end of July.  This is also greatly overvalued and well into bubble territory.  Like the S&P 500, the important Dow Jones Industrial Average could be slashed in half and still be overvalued on a fundamental earnings basis.


The great American casino of the NASDAQ looks even more dismal from a valuation standpoint.  As of July 31, when the NASDAQ composite was trading at 2027, the 100 biggest and best stocks on the NASDAQ had a MCWA P/E of an astonishing 44.7!  Even with the late August NASDAQ carnage, this number will still likely be much higher than the S&P 500 and DJIA overvaluation when the final August numbers are crunched.


With valuations still at historical extreme ranges in all the major US equity indices, a virtually airtight case can be made that the investor emotion of greed still dominates popular investor psychology.  When fear becomes the most powerful emotion in the broad markets as it ultimately did after all the past bubbles we mentioned above, stock index P/E ratios will plunge below their historic average of 13.5 times earnings.  It is not uncommon for markets in the bust phase after a bubble to see their P/Es plummet below 10 all the way down to 6 or 7, around half the normal average valuation.


While it can be hard to believe after all the equity market mayhem we have experienced in the United States, one of the most objective empirical indicators of market sentiment, valuation, still shows that market psychology continues to drown in pervasive greed.  Will this autumn be marked by even more extreme levels of investor greed, with the average investor sending checks to Wall Street to push already overvalued stocks even higher?  Or will this autumn witness investors grow frightened and begin selling the overvalued stocks they still hold?  To attempt to address this question requires a further foray into investor psychology.


In addition to the two key emotional elements of greed and fear, two other important elements also interact to forge investor psychology, expectations and circumstances.


Expectations are very important in all aspects of life.  Expectations are the philosophical basis of contract law, for instance.  In the business world, when someone says they will do something, whether in a written or verbal form, the counterparty to the contract expects it to be done.  In our personal lives, if a friend or family member tells us they will do something, we expect it to be as good as done.  Our expectations are set when others tell us what they intend to do or what they expect to happen.  When our expectations are exceeded we are happy, and when our expectations are not met we get upset or down.  Expectations are a critical part of our entire lives, especially that part where we are investors.


Since the NASDAQ bubble burst last March, Wall Street and the financial media have been executing a 24/7 blitzkrieg propaganda campaign aggressively trying to convince investors that an economic and stock market recovery is right around the corner, right over the next hill, right after the current quarter.  The stakes to this great expectations game are stellar, as Wall Street is well aware the markets are now in a very precarious position and will fall far, far lower if the average investor gives up and sells his or her stocks to move their capital to safety.


Some examples of Wall Street expectation setting include the following popular mantras repeated over and over again ad infinitum in the popular mainstream financial media…  “The stock market always rises when the Fed cuts rates.”  “The US consumer will spend and rescue the economy.”  “The US stock markets bottomed in April.”  “The economic recovery is coming in Q4 2001.”  “Long-term investors just have to buy and hold to make money.”  “The Fed is acting aggressively to bring the economy in for a soft landing.”  “We have seen the worst and the economy is looking up.”  “Things can’t get any worse.”  We have all heard these trendy Wall Street platitudes, and the list goes on and on.


A large component of the eventual slant of general market psychology this autumn depends on whether those high expectations that have been continually set with investors by Wall Street in the past year or so will finally be met in the final months of 2001.  The Wall Street establishment is praying that these lofty expectations they have set actually come into fruition, but unfortunately the prospects of any meaningful recovery this year grow bleaker with each passing day.  Every evening we hear more announcements of layoffs, more corporate profit warnings, and ever more bad news for the economy and the stock markets.  By only watching bubblevision and the mainstream media one could draw the conclusion that these rapid-fire negative developments are a total surprise, but the contrarian community has been discussing and predicting them all year.


We, as contrarians of course, don’t believe these high Wall Street expectations will be realized this year.  In January 2001 we published a couple essays (“The Greenspan Gambit” and “Bubbling Interest Rates”) explaining why the Federal Reserve was probably doomed to failure in vainly trying to reinflate a collapsing equity bubble.  In April we published an essay (“Consumers to Rescue Wall Street?”) where we outlined why the US consumer will be in no position to bailout the equity bulls.  In May we published another essay (“Equity Bulls in Denial”) where we explained why the April lows in the US equity markets were nowhere near the final bottoms.


When the average US investor faces the very high probability dire prospect that his or her stellar expectations for something miraculous to happen in the economy and markets in the waning months of 2001 are not likely to be achieved, there is a high chance that widespread discouragement will set in.  As long-held expectations of recovery relentlessly created and reinforced by Wall Street all year are unceremoniously shattered in the third and fourth quarters of 2001, we expect that investors will gradually move from a greed based worldview of the US markets to a fear-based worldview.  As investors become disenchanted and then frightened and frantic to preserve their scarce capital in the wake of perpetually broken bullish expectations, selling pressure will intensify greatly.


In addition to shattered expectations, many US investors are likely to become slaves to adverse financial circumstances this autumn.  No matter how bullish someone may be on the US equity markets, they can’t send money to bid up stock prices if they don’t have the cash.  With the enormous number of layoffs, ballooning consumer debt exceeding record levels, the dwindling of cash harvested from refinancing houses earlier this year, and the dismal US savings rate, it is unlikely that the US consumer will be able to support the equity markets.  With little or no surplus cash, consumers will NOT have the ability to bolster Wall Street this autumn by either buying corporate products to produce corporate revenues and profits nor by investing in shares of US equities to further bid up prices.  As the real financial circumstances in legions of American consumer/investors’ lives turn south this autumn, popular investor psychology is likely to follow.


To summarize thus far, market psychology is a critical driver of market direction and price levels, current valuation levels of all the major US indices remain near breathtaking heights, high investor expectations are unlikely to be met, and the financial circumstances of many average American investors are deteriorating rapidly.  Mix all these elements together and add autumn and you get a bitter recipe that looks like it does not bode well for the US equity markets in the coming months.


The psychology of autumn itself could interact with all these factors to create an even more negative environment for the US stock markets.


Since I grew up in the cold northern United States, I really understand the weather component of the psychology of autumn well.  As the days grow shorter and the weather gets colder, much of the latent joy of summer evaporates.  The leaves begin to wither and fall from the trees and chill winds blow, indicating that the dark and dreary winter months are rapidly approaching.  This alone has a huge negative impact on general psychology as people become more socially withdrawn and less exuberant as the last days of summer fade.  As autumn begins to assault most of the United States, there is a noticeable shift in general psychology and outlook amongst Americans.


In addition to the weather components, the psychology of autumn is one of nose-to-the-grindstone work.  Kids go back to school and big kids go back to college.  There are no holidays in the States between Labor Day and Thanksgiving, and people began to work hard and focus on the projects they let slide during the summer.  These aspects of autumn tend to wash out the remnants of the exhilaration of summer from the psyche and bring emotions back down to a more even and rational keel.


In investing, autumn psychology also has the added effect of ushering in a kind of stoic realism on the markets.  Investors can finally see the end of the year only a few months away and they realize that they soon need to make tough decisions on selling losers for tax losses or holding into the following year.  Investors also take a renewed critical look at Wall Street’s claims about the markets.  January predictions by Wall Street superstars and gurus for year-end closes are also reevaluated during this period and adjusted as they began to look more unrealistic in light of the year’s market events.  Autumn affects the investor’s mindset in a myriad of fascinating ways.


Perhaps this pervasive autumn psychology shift in the northern hemisphere is one reason why September and October are typically among the toughest and most dangerous months for the US equity markets.  The gloomy market lore that has accumulated around October in particular is legendary.  Last year we hammered out an essay on this phenomenon titled “Red October”.  September and October this year are shaping up to once again be perilous months to be long equities.


At this moment, from our perspective standing before the Labor Day holiday that straddles the unofficial demarcation point between summer and autumn in the United States, it sure appears that 2001 will prove to be a dangerous and challenging autumn for equity market participants.  Several negative factors are swiftly converging to create an environment where it is highly probable that much more stock will be sold than will be bought, pushing all the major US markets lower.


Valuations remain extreme, investor expectations of a rosy year-end are unlikely to be met, the circumstances of the US consumer/investor are deteriorating rapidly, and the usual negative autumn psychology will begin to kick in right after Labor Day.  These powerful forces will run head-long into the beginning of the third quarter earnings warning season in mid-September which is also shaping up to be ugly.  The resulting market turmoil will not be good news for the equity perma-bulls.


With all these decidedly negative influences on the US equity markets converging, we believe the next couple months will be highly volatile and dangerous, with a high probability of the bear market in all major US equity indices continuing.  We will probably witness occasional sharp and spectacular bear market rallies to punctuate the fall, but the overall trend looks dismal.  We fully suspect that, just like this summer, the players making the big money in equities in the next couple months will be the ones selling short or betting on further market declines through put options.


Investors usually realize that having to face the psychology of autumn in a normal year can be stressful enough, but having the dark psychology of autumn interact and ferment with other crucial negative fundamental factors after a bubble burst is leading to an equity market environment of extreme risk.  Caveat Emptor.


Adam Hamilton, CPA     August 31, 2001     Subscribe