SERIOUS MONEY:THE BEAR market that began last autumn reached fever pitch last week as stock prices dropped to the lowest level in 2½ years, but they have since registered a meaningful rally, surpassing both their five-year and 10- year moving averages, writes Charlie Fell.
Has the market hit bottom? The burgeoning fields of behavioural finance and neuroeconomics provide some important clues.
Classical economic theory assumes that market participants are rational wealth-maximisers who choose among a set of alternatives that course of action which maximises wellbeing. "Homo economicus" has been a fundamental tool of economic analysis for decades and has contributed to considerable advancements in asset-pricing theories over the past half-century.
All of the advancements are predicated on the notion that markets are informationally efficient or the idea that markets fully, accurately and instantaneously incorporate all available information into market prices.
If prices reflect all information and the expectations of all market participants then price changes must be unpredictable. Clearly, the theory is at odds with the substantial capital under management at active investment firms but counter-intuitively, the greater the monies chasing uncovered profit opportunities the more efficient markets become, and the greater the randomness in price changes thereof.
Classical economic theory, however, posits how individuals should behave, not how they actually behave; fortunately for active investors, the emerging fields of behavioural finance and neuroeconomics reveal that economic man's decision-making process is not so cold and calculated after all.
Rational decision-making combines both an analytical and an intuitive or "gut feeling" processing mechanism. Classical theory does not allow for emotions, but research by neuroscientist Antonio Damasio confirms that intuitive reasoning is part and parcel of successful decision-making. Indeed, impaired feelings and poor decisions go hand in hand.
The intuitive processing system is rapid, effective and occurs without conscious thought, while the analytical system is slow and requires justification via logic and evidence. The former system evolved over millions of years of primate evolution and has barely advanced for thousands of years.
Indeed, the discovery of a 154,000- year-old homo sapien's skull in Ethiopia a decade ago confirmed that it was no smaller than that of the average person today. This discovery means that the intuitive system is more likely to be better equipped to solve the problems that faced hunter-gatherers 200,000 years ago rather than the complex challenges of the modern world.
This is particularly true of financial markets, where problems are complex while information is incomplete, ambiguous and constantly changing. Under such circumstances the intuitive system typically overrules even deliberately formed intentions leading to sub-optimal decision-making.
Investors' decision-making is subject to cues inherited from the ancestral environment that can lead to mispricing and profit opportunities thereof for the astute. This is likely to happen if investors' behaviour is systematically biased. Most often this will not be the case, but at major turning points behaviour is often highly correlated, giving rise to euphoria at market peaks and panic at lows. The overreaction presents opportunity to those who monitor the mind of the market.
A bear markets typically proceeds through three distinct psychological phases - denial, concern and capitulation, which stem from psychological traits inherited from our ancestors including overconfidence, pattern-seeking and "safety in numbers".
Over-confidence arising from the large gains during the bull cycle means that investors dismiss the initial downdraft in stock prices. This is the denial phase. The setback will be viewed as a healthy development and not the emergence of a new pattern. Evidence to the contrary will typically be ignored.
Indeed, some investors may increase their equity exposure given their continued bullish outlook.
The subsequent rally typically fails to record new highs and stock prices are carried to lower lows during the concern phase. Stock price weakness does not arise from a deluge of selling but a sharp fall in buying activity that stems from increased risk aversion in the face of further losses. Selling remains muted as pride motivates investors to avoid taking losses and the unpleasant feelings associated with being wrong. The notion that there's "safety in numbers" also contributes to inaction.
The concern phase leads to an uptick in the number of meetings with stock market seers to assess the situation. Unfortunately, the experts consulted are typically those that concur with the investor's bullish opinion and the investor's beliefs remain in place.
However, as new information continues to challenge the entrenched view, investors have no option but to update their opinions and throw in the towel.
The capitulation phase begins as investors' opinions are updated. Investors sell into a declining market, often reacting to the trend in prices rather than new information.
The panic selling arises because the losses accrued to date heighten the sensitivity to further losses. This phase sees the stock market enter a steep decline and volatility increase as prices approach bottom.
The psychological symptoms evident at market bottoms appear to be evident today. Both bullish and bearish sentiment have reached levels that were seen at previous market lows in the 1970s and 1980s, while the number of stocks recording new lows has jumped to a cycle high. Meanwhile, both trading volume and volatility have registered sizeable increases. The secular bear market is far from over, but recent price action suggests that investors can expect a temporary reprieve.
