Once you’ve been around the investment block a few times, it’s hard to take textbook economics – with its calm and collected Vulcan investors and its perfect pricing – very seriously.
Just as there’s a business cycle, there’s clearly an investment sentiment cycle, which sees the emotions of investors surge and wane as they lurch from fear to greed and back again.
That’s not to say the weaker form of the Efficient Market Hypothesis is wrong. Modern behavioural economists are surely correct that investors often act irrationally, but you still might not be able to profit from it.
In other words, a share’s price may well reflect everything that’s known about an asset – including the fact that half the people buying it are irrationally exuberant first-time traders without a clue.
And yet it can still go higher.
Hunting for highs and lows
It’s only in retrospect that you can clearly read back any particular cycle of fear and greed – even when you understand that bull and bear markets are at least partly emotional, and you’re alert to all the signs.
Often you’ll see optimism and reckless trading long before a particular market tops out. The great economist Keynes said “the market can remain irrational long after you can remain solvent”; what he didn’t mention was that even if you avoid betting against a crazy market, you can still feel pretty lousy in your haughty solvency when everyone else is making out like bandits.
I’ve been there. For instance, I’ve avoided gold miners for years, despite their popularity, because gold has long seemed detached from reality. More fool me.
It was a similar story with oil explorers. I rode the early part of the bull cycle until 2006 or so, and then jumped off when I saw a bandwagon forming. And the wheels did come off in 2008, as hedge funds sold anything they could to raise money in the vicious bear market.
But it was soon trundling along faster than ever again.
In fact, it seems like every private investor I meet nowadays owns a portfolio of oil companies, variously prospecting in the Mongolian steppes or trying to snake a pipe under the Arctic.
These people (maybe you’re one?) will tell you earnestly that oil shares are the only game in town, and peak oil makes all other investments irrelevant.
Indeed as far as I can tell, every 50-year old man who dabbles in shares (and they’re always men and over 50 these days, which says something in itself) thinks humanity’s future is to transport bundles of copper and gold back and forth between China and India in gas-guzzling trucks at great profit to themselves, while the rest of the world burns its old Tesco share certificates and 50 pound notes for warmth.
No place for media companies. No point in buying shares in breweries or builders. No future for whoever makes those fancy leggings that all the girls in London are wearing.
These peak oil investors have endless technical arguments as to why they’re not the last punters to turn up before midnight. They are supremely confident, and they grow more confident by the day.
We’ll see, but history is not on their side – all one-way bets hit the wall eventually.
Dot come again
For a contrasting unloved sector, consider technology companies.
It’s hard to remember a time when half the office owned shares in nonsense companies like Baltimore, Webvan, and NTX. Yet it was only a brief decade ago that the Dotcom stocks were doubling in a month on a good press release and a name change.
Today roughly nobody except institutional investors bothers with individual technology shares – yet the Nasdaq tech market in the US has been quietly beating the Dow and the S&P 500 for months.
Maybe the seeds are being planted for a new boom in technology share investing:
- The first shoots will be obscure magazine articles on the Nasdaq’s recovery.
- Then you’ll discover a friend or a bulletin board poster who has tripled his money betting on cloud computing micro-caps.
- Perhaps Facebook or Twitter will float for what will seem a crazy valuation, but will look positively modest a few years later.
- Some new kind of fusion or computer or website will emerge and capture everyone’s attention.
- Whereas today there’s less than half a dozen surviving UK funds focused on technology, by then there’ll be dozens. You can’t miss them – they’ll be advertised in all the Sunday papers.
- The last lemon will ripen in 2020, when even you and I will buy shares in a Korean software company that’s a rumor we heard from an old boss who’s confused it with gadget in a movie he saw on the first commercial space flight to the moon.
And then the bubble will burst. We’ll all wonder again what we were thinking, and put our savings into ‘risk-free’ Chinese government bonds and middle-class apartment blocks in New Dehli.
A cycle for all seasons
I exaggerate, clearly – I don’t know how the next bull market will play out. Maybe it’s not the turn of technology shares again quite yet. Maybe investors will go mad for Chinese small caps or German widget makers instead.
The important point is that knowing about the sentiment cycle is helpful, whatever kind of investor you are and wherever we are along it:
- You should understand your own emotions – why we all feel fearful, brave, or even guilty at different times.
- If you’re an active investor, you can potentially profit by guessing how others are feeling, and placing your bets accordingly.
- If you’re a passive investor, the cycle explains why you should keep on investing through the market’s ups and downs. Far from being ignorant, you’re wisely taking advantage of the oscillating and unprofitable emotions of your fellow investors.
In part two I’ll look at attempts to define the stages of the investor sentiment cycle more precisely. Subscribe to make sure you get the post!