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The investor sentiment cycle

There’s a sentiment cycle governing investors’ emotions.

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.

Peak bullshit

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!

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{ 6 comments… add one }
  • 1 you be the bank December 10, 2010, 5:24 pm

    all i can say is that it scares me to see words like “guessing” and “placing your bets” I don’t know why anyone in their right mind would at this time put any of the money they need for retirement at risk. Does america understand that when you contribute to a government sponsored plan you are not saving you are investing, which means you could lose all that money. we need to learn how to SAVE for retirement not ‘place our bets’ on our portfolios and invest for retirement.

  • 2 Nanette Byrnes December 10, 2010, 6:16 pm

    Interesting piece. Looking at sentiment through the prism of what sectors or investment stories are hot is probably a better route than the sentiment indexes that try to reflect our feelings toward the market overall. The American Association of Individual Investors’ sentiment gage has been zig zagging all over the place this year. It’s thought of as a reliable counter-indicator of where the markets headed, and those tea leaves were getting pretty hard to read. Then I read a piece in the Wall Street Journal about how small the sample size is — 200 to 300 self-selected investors, many retired, probably the same core bunch every week. In polite terms “not statistically valid.” Here’s a link to that story if you’re interested: http://online.wsj.com/article/SB10001424052748704447604576007920154277428.html?KEYWORDS=investor+sentiment
    .-= Nanette Byrnes on: Volatility in Government Bonds =-.

  • 3 ermine December 10, 2010, 10:03 pm

    Well, I fit most of the criteria of the peak oilers, with the exception that I haven’t got any oil shares (other than presumably in a index ETF and in an IT).

    The trouble with peak oil, is that if it comes to pass, is that it will sock it so very hard to the fundamental assumptions of capitalism that you’d need the talent of Buffett or Soros to make any money out of it, whatever money may mean by then.

    There are some things you can’t fight with investments. Peak oil is one of them. A litre of petrol is about 10KWh of stored energy, that’s about equivalent to the human output of two weeks of hard physical labour for 8 hours a day. It’s a snip at £1.20 That’s why to be rich in the pre-oil age you needed to have servants or slaves. People may be able to get away with just servants post PO if we play our cards well 😉

    I agree, if there are guys that reckon their oil shares will hedge peak oil they’re away with the fairies.
    .-= ermine on: Why index investing doesn’t cut it for me =-.

  • 4 OldPro December 11, 2010, 10:45 am

    “Animal Spirits” Keynes called the hunger for risk… I sense the spirits are rising even in my splendid isolation, of today… well, relatively splendid: don’t tell the wife.

    To “ermine”, I would say I have heard many theories in my long life… Does anyone remember any more that the world was going to freeze? Yes, that’s what they told us in the 1970s… I am not a global warming denier, but I do deny inevitable catastrophe. We see the threat, not the blind side that’ll hit us… personally it’s a fatal flu epidemic I fear.

  • 5 ermine December 11, 2010, 9:01 pm

    > any more that the world was going to freeze?

    Yeah, I remember hearing that at school 🙂 Climate change, however, isn’t the same as peak oil, and there are a lot more potential consumers coming on line than the 500-750 million or so of the original Western World from the 1950s to the 2010s. It’s not been getting easier to find oil since the 1960s and the demand could increase by 5-10 times if we all want to live an American lifestyle. However, I do acknowledge that human ingenuity hasn’t run into a brick wall so far!
    .-= ermine on: Why index investing doesn’t cut it for me =-.

  • 6 Mark Carter February 12, 2011, 10:21 pm

    My own theory is that even if you accept Peak Oil and oil prices going up ever-higher in future, that still doesn’t mean it’s beneficial for the oil companies. Prices may go up, but volumes will go down. My argument is marginal costs will go up as oil producers find it increasingly difficult to obtain oil. It’s a scenario in which nobody wins.

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