“My Two Cents”
By Andy Sutton

10/6/2006

A sometimes unheralded but all too important sideline to the study of markets is the study of market psychology. After all, markets are not inanimate objects; they are a collective term for all the participants who happen to be engaging in the trade of securities at any given time. Today's market is not tomorrow's market. There are people on the sidelines today who will be in the game tomorrow and so forth. That said, there are critical junctures in any market move and probably the most important of all is when you have everyone pointing in the same direction.

I'll cite some prior examples of this phenomenon. NASDAQ 1999. This is probably the most notorious, but it was one very crucial time in market history when everyone was on the same side of the fence. You really would have had to kick over some serious rocks to find anyone who thought that Etoys wasn't going to $500/share. Sure, there were folks out there who were skeptical, but they were few and far between, and more importantly, they were nonexistent in the mainstream financial press.

The financial press plays a very important role in the movement of markets and market psychology. Too many times the 'Chief Economists' on these shows are anything but, having attained fewer academic credentials in Economics than even your editor. Even if they have achieved substantial academic or field-related success, I'll be the first to admit that if they believe everything they heard in the classroom that they're a danger to their own portfolio as well as everyone else's. But we have to recognize the important role these people play nevertheless. The average American hasn't any idea about how money really works, how credit is created and destroyed, and how too much excess money sloshing around makes their groceries more expensive. We cannot all be experts in every field so we have to rely on others to guide us. The financial arena is no different. The investor is constantly bombarded with tidbits of news and acts accordingly.

Fast forward to 2005. The housing boom was in full swing. Rates of appreciation were in the double digits in many areas, buyers were plentiful, and it got to a critical mass where almost everyone believed that it could only continue. That conflagration of opinions signaled an important market top and we've been on the way down, albeit slowly, ever since.

It all comes back to psychology. Most people are afraid to invest in something until it has 'proven' itself. Time and time again we see a fundamental run up in the price of something, only to see it buckle and correct. The attitude is that it isn't a sound investment and people are wary and easily shaken from the market. This is called 'soft money'. The problem lies in the fact that perhaps there really is a fundamental reason to be buying and that by the time that fact is accepted, the price is generally much higher. Gold is fine example. Few wanted gold when it was $250 per ounce, but when it got to $500 and had 'proven itself', buyers were everywhere. But alas, the money had no conviction and was easily shaken out after a couple of precipitous falls. But the fundamentals never disappeared. In fact, they’re now stronger than ever.

Stock markets are the same way. The logical action is to buy low (out of favor) and sell high (in favor). But we are unsure, so we wait for the 'sure thing' and all too often buy late and lose potential profits. The point is a simple one: by the time everyone is on board with a particular company, sector or commodity, the opportunity to buy is long gone. The easy money has already been made. Which brings us full circle to the current situation on Wall Street. The chips are falling into place for another Fed-orchestrated 'soft-landing'. Interest rates have been coaxed down through the curious mechanism of the trade deficit. Huh? By running record trade deficits, the government has ensured that foreigners will be flush with dollars, providing instant demand for Treasuries. So these foreign investors bid up Treasuries, driving down yields thereby throwing a life raft to over leveraged homeowners in the form of lower interest rates when they have to refinance. This may not work though; only time will tell. It doesn't matter. The perception is that the Fed has once again found a rabbit in the bottom of the proverbial hat and we can continue the party. One by one the bears, even the perma-bears like Steven Roach and Richard Russell are jumping the fence and converting to the 'soft-landing' thesis. The DJIA moved past 11,800 today, a nominal all-time high, as a result of all the optimism. To put it mildly, now is an awful time to buy, but a much better time to either sell or wait.

We have only two tools at our disposal with which to analyze the current situation. One is history, the other, common sense. Neither paints a pretty picture for the future despite a barrage of positive rhetoric saying otherwise. Many folks are clinging to the belief that 'this time it really is different'. They may be right, but I'm not betting the farm on it.

Once again, we are seeing the beginnings of a previously lethal sequence of events where the 'market' consists of players who are all on the same side of the fence. It's ok to be the last man standing on the other side but there is no prize for being the last one left standing when the music stops.

Andy Sutton holds an MBA in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics.

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