Psychology of Markets - Herd Mentality

Herd mentality is a behavioral phenomenon that was around long before stock markets arrived.  Since the dawn of man, we have been influenced by our peers to adopt certain behaviors, partake in trends and rather simply, just try to fit in.

The theme is no different when it’s applied to investing.  Most participants in the market enjoy the comfort of others when making investment decisions.  They see other investors enter into a market, a sector, a stock, etc and that relieves whatever reservations they may have held and emboldens them to join the fray.  One of the more common causes of herd behavior is that investors tend to follow performance.  So you’ll see a stock or an asset class go on a powerful run only to have the masses plow in once the secret is out and willing buyers are no where to be found.  

This sequence repeats and reveals itself in all facets of life including investing and will do so until the end of time which for a moment we feared was happening yesterday as llamas were running free on our streets and people thought a blue and black dress was actually white and gold.  Alas, we woke up this morning having lived to tweet about it.

It's the sequence described above that has given way to some of the biggest speculative bubbles in history.   From the Dutch tulip craze in the 1600s, to the dot com bubble and the 2007-2008 real estate bust, all were fueled by the spectacular greed of herd mentality.  While a few were granted incredible riches during these manias, many more suffered severe financial impairment.  And often times it was caused by no other reason than just wanting a piece of what everyone else was doing.  Your neighbor was flipping houses, your brother was day trading, your great-great-great-great-great grandfather was convinced that tulip bulbs held all the world’s secrets.  The fallout from these boom and bust cycles have given way to some of investing's most well known lessons and quotes:

“Be fearful when others are greedy and greedy when others are fearful.” – Buffett

"The stock market is filled with individuals who know the price of everything, but the value of nothing." – Phillip Fisher

Josh Brown had a recent post on the topic of scarcity.  Not just scarcity in the markets but life in general.  The post really resonates on a number of levels.  On the topic of herds, he references two companies making a ton of headlines and money right now, Uber and Shake Shack:

“The stock market won’t go down because too many people need it to. It’s not rocket science.

Uber is worth $40 billion. Not the business, mind you, the private-market shares. The business is probably worth a lot, but not $40 billion. But the shares are because they are scarce. You can’t be a venture capitalist and not own them, or have access to them. What kind of a piker VC misses out on Uber? It’s like being at a monster truck rally and not having that t-shirt where the Ford pisses on the Chevy. You may as well go home. That’s why they’ll pay any amount.

Goldman Sachs struck a deal to get access to pre-IPO Uber shares for their wealth management clients. Those clients will never bring up performance, management fees or commissions ever again. The scarce resource covers a lot of ground and works magic wherever it goes.

Same with Shake Shack’s newly minted shares. There’s only one Shake Shack; if you manage a growth fund and miss out on what could be “the next Chipotle”, you’re fired. So you just pay for it. Seven times enterprise value to sales? YOLO. Eight firms on Wall Street initiated coverage of SHAK yesterday. All but one has it as a “neutral” or a “market perform” rating. Every single analyst said the same thing – I’m paraphrasing here – “God, we wish this thing would come down ten points.” That’s how you know it probably won’t, and they’ll be upgrading it later, higher. There’s only one…”

One of the themes within Josh’s comments echo the quote from Phillip Fisher above.  While the folks at the big VC firms and investment banks may see long term opportunity in companies like Uber and Shake Shack, that’s not necessarily the driving force behind their decision to buy a piece of the action RIGHT NOW.  They are buying because of the massive influence of their herd (their peers and clients).  Most do not want to be the contrarian in this trade.  It’s simply easier to follow the masses, play hot potato and just hope you’re not the one holding the stock when the music stops.

BABA would be another recent example of this behavior.  Its IPO last fall was touted for months.  CNBC covered it like a presidential inauguration and we saw people clamoring to get into BABA at any cost.  And for a time that was fine.  The stock IPO’d and rose powerfully.  Now we’ve seen the shine wear off and it’s fallen 30% over the last 3 months. 

We’re not looking to take any long term stance on the direction of BABA’s stock price but there's no doubt that initial post-IPO surge was in no small way influenced by herd behavior.

As you fine tune your process, make sure that you’ve uncovered ways to filter news and outside influences.  It’s always important to hear differing thought and opinion but make sure it’s done so in a manner than does not unhinge your clear headed thinking.  Respect the moves of the herd but don't follow it blindly.

2/24/15 Market Update: Nasdaq's Streak

Today's Investor's Business Daily ran an interesting stat on the current move in the Nasdaq:

"It's a rare feat for the Nasdaq to move up eight or more days in a row.  Monday marked the ninth time since the March 2009 market follow-through that the composite has been up eight days in a row or more.  Half the time, the streaks ended with the market pulling back or turning choppy.  The other half of the time there have been declines of 5% to 19%."

We wanted to dig deeper into this commentary and see exactly how the market performed after each of the 8 prior occurrences.  The results are listed below:

Final Day of Streak	Days Up in a Row	Peak Date	Trough Date	Peak to Trough
7/23/2009	12	8/4/2009	8/17/2009	-4.218%
9/20/2010	9	Higher by 10.1% till 11/9/10 peak
10/29/2010	8	11/9/2010	11/16/2010	-5.131%
12/10/2010	8	Higher by 7.7% till 2/18/11 peak
4/29/2011	8	5/2/2011	6/16/2011	-9.976%
7/7/2011	8	7/7/2011	10/4/2011	-20.153%
7/15/2013	8	8/5/2013	8/27/2013	-3.276%
2/18/2014	8	3/6/2014	4/15/2014	-9.723%

The data shows that in 6 of the prior 8 instances the market (read: Nasdaq) has been prone to pulling back after achieving an 8th consecutive "up" day.  3 of the pullbacks were rather significant (-9%, -20% and -9%) while the other 3 were minor.  There were 2 occasions when the market chose to continue on higher for an extended time.

We then expanded on this theme and examined how the Nasdaq had reacted after each of the 8 prior streaks over various short and intermediate timeframes.  The results below show that buying such sustained strength on average has not been nearly as rewarded as buying on any given day.

	Nas +5Days	Nas +10	Nas +20	Nas +50
Buying the Last Day of the Winning Streak	-0.136%	-0.028%	-0.133%	1.283%
Whole Sample	0.456%	0.909%	1.761%	4.087%

This supports the argument that buying strength has been challenging for the last few years of this bull market.  A strategy of buying dips and pullbacks has been far more rewarding.

Recent history would suggest a bit of caution is warranted here when looking to add long exposure.  Look forward to seeing how it plays out this time.

Week in Review (Feb. 16 - 20)

The markets finished the holiday shortened week on a high note as Friday brought new closing highs on a number of indexes.  The market was encouraged by news out of Greece that an agreement had been reached to extend its bailout by 4 months.  Regardless of the ultimate success or failure of said agreement, the market viewed it as bullish in the short-term and ran equities to new closing highs across the board. 

The Dow and NYSE finally hit new closing highs following the strength of Nasdaq, S&P 500, S&P Midcap 400, and Russell 2k.  The last index we're watching to complete a triple crown of sorts would be the Transports.  They've yet to do so but are inching closer.

One thing that could be viewed as worrisome is breadth.  There's still lagging breadth in the S&P 500 but we'll attribute that to the weakness in the energy space and give it a pass for now.  However, the current leading index, the S&P Midcap 400, is showing similar traits as the % of stocks above their 10, 20, 50, and 200 day moving averages have yet to break out to highs with the index.  Momentum peaked towards the end of October and early November and has yet to take out those highs.  That will be needed in order to sustain the current moves to new highs.

Market Update - 2/19/2015

We've currently broken out of the trading range in the S&P that we originally highlighted on February 7th.  The S&P has cracked upside resistance at 2064 while also taking out the previous high of 2093.  For this breakout to last we need to see further progress.  I continue to believe prolonged rallies will be a difficult task for the bulls.  But the market doesn't care what I think so lets look at some things that have changed and what's remained in recent days. 

In the bulls favor is the healthy amount of leadership stocks that have gapped up on earnings and held their gaps.  Many institutional quality stocks from slower stable earnings plays to high flying growth types continue to make higher highs.  This is healthy and needed for the market to sustain an uptrend.  The difference now versus the last few months is the confirmation in multiple indexes into new highs.  The S&P, Nasdaq, Russell 2k, and Mid Caps all are trading into new high territory.  While the DOW and NYSE are lagging, having the other four confirm is good news.  

The bad news is we are still constrained in a giant channel limiting upside progress.  This has been the case for roughly 3 years.  Once we trade to the upside channel the market has tended to become overbought and ripe for a pullback.  As we see it, the market has started to show some of those signs on our indicators.  Also, upper channel resistance remains above current levels but not by much.  While breaking out of the channel to the upside is always a possibility the higher probability play has been to fade these areas. 

Below is a weekly chart of the S&P since the end of 2011 highlighting the channel support and resistance.

Psychology of Markets - Hindsight Bias

Over the next several Thursday's, we'll continue looking at various aspects surrounding market/investor psychology and the dramatic effects that emotion and biases have on results.  

Last week we covered confirmation bias.  Today we'll venture down a similar road with hindsight bias which occurs in instances where a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted.

Simply put: it's the all too common phenomenon of saying to ourselves "I knew it all along!"  

Additionally, we as investors have a powerful tendency to recall our forecasts as being better than they really were.  And that makes a lot of sense from a broader perspective.  If the majority of people were completely honest with themselves when assessing their investment success and acumen there'd likely be far fewer individuals handling their own investments.  Anecdotally, we've seen more than a few cases where investors and advisors alike have rather rosy recollections of their past challenges and failures.  You'd be surprised just how many will tell you they saw the dot com and housing bubbles coming and were able to dutifully protect capital....While true in some instances this certainly was not the majority outcome.

This comes as a timely (or depending on your rooting interests, horrible) opportunity to bring up hindsight bias as we just witnessed a thrilling Super Bowl that ended with tons of criticism, second guessing and Monday Morning Quarterbacking.  The heart of the matter being, as we all know, the Seahawks decision to throw from the Patriot's 1-yard line instead of running Marshawn Lynch.  We'll leave our personal opinion of Pete Carroll's decision out of it since we're Redskins fans and have too many of our own issues to worry over.  

However, what many critics fail to bring into consideration is that Carroll made a very similar decision just before halftime that resulted in a Seahawks touchdown.  With 6 seconds left in the 1st half, Seattle ran a play instead of settling for a field goal attempt.  This was a risky proposition but since it resulted in a touchdown it was casually hailed as the proper call.  Fast forward a few hours and the Patriots are celebrating another title after intercepting Russell Wilson in the end zone. In the minutes, hours and days since the game, the focus on Carroll's play-call has nearly overshadowed the Patriot's victory.  

The common conclusion has been: "Worst coaching decision in football history."

However, if looked at analytically and stripping away any hindsight biases, Carroll seems to have made a reasonable statistical decision.  FiveThirtyEight.com went into fascinating detail looking at the various scenarios surrounding the fateful play.  In fact, their analysis shows Bill Belichick as the coach that made the poor coaching decision based on statistics by not calling time-out.  However, statistics and probabilities do not always make for certainties and viewers/commentators were able to immediately reshape their narratives and declare this a boneheaded play-call.  A call that they surely never would have made if put in that position.

Humans have an innate need to make sense of the things happening around them.  Often times this results in us forming a view that makes events appear as if they were predictable.  There are few places more harmful for hindsight bias to take hold than in investing.  It frequently leads to overconfidence and an oversimplification of outcomes.

When fine tuning your investment process, make sure you're using completely honest assessments and be your own biggest critic.  Acknowledge your successes but examine and really deconstruct your losses.  That's where the best lessons are learned.

And if you're not making this face when reviewing some of your losing trades... 

...you're probably being too easy on yourself.