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FOMO and Market Dips

Guest post by Michael Wagner

“Buy the dip.” Even those who are only somewhat familiar with the stock market have likely come across this advice. The logic is simple. Over long periods of time, the stock market tends to “go up”; over shorter periods of time it can and frequently does “go down”; and the lower one’s entry price, the greater the gains experienced when the market goes up. Everyone likes a deal, and “the dip” is the stock market equivalent of a discount sale. Or so the wisdom goes.

In all the talk about “the market”, from blogs like this one to the Wall Street Journal to Fox Business channel, it is sometimes easy to lose sight of what the market really is. In short, it is a group of investors, some individuals and some working on behalf of others, buying and selling securities (stocks, bonds, mutual funds, ETFs, etc.) amongst themselves. That’s it, just a group of humans trading with each other, each trying to secure the right investments for the best price. As with any group of humans, then, there are mistakes, failings, and frailties in the midst of all this activity. The study of these shortcomings is the subject of behavioral finance.

One of the most well-documented investor phenomena in the behavioral finance literature is a concept known as herding, which is the tendency of investors to follow the trend, whatever it is, due to lack of knowledge or perhaps due to “FOMO”—the fear of missing out on the latest rally. When inserted into this crowd mentality, a concept such as “buy the dip” can initially have a somewhat counter-intuitive effect. The more investors conditioned to buy the dip, the more buyers there are to step into even fairly minor selloffs, keeping the “bulls” fat and happy. Not a bad thing, right?

Before you buy the dip, though, you might want to consider this: why is “the market” (specifically the stock, bond, mutual fund, ETF or other financial instrument of interest) on sale in the first place? It could be that the seller has incorrectly decided his piece of the market has become overvalued or perhaps he just needs some cash. On the other hand, he could be right in his assessment that the risk of holding the security outweighs the benefit of continuing to hold it.

In today’s world, there are a number of significant risks of which to be mindful. Yes, North Korea has a history of crying wolf, but if you remember the story, the wolf does eventually come. How about the “Trump bump” that sent markets soaring after the election on expectations of significant healthcare and tax reform and increased investment in infrastructure? President Trump unexpectedly cut a deal with the Democrats this month to fund the government for a short while longer, but at some point investors are likely to give up on their hopes for and promises from an Administration that seems unable to whip its Congressional majority into working order. This week the Federal Reserve tipped its hand that interest rates might rise before year end. Central banks around the world, including the Fed, are indicating that they may start soon to gradually tighten their easy money policies after a decade of flooding global financial markets with liquidity. We all know what this liquidity has done for markets. While there continues to be a notion in the popular financial press of growing economies, soft economic data both in the United States and abroad leaves room to contemplate less optimistic assessments of global economic strength.

These are but a few of the many complex dynamics that investors must grapple with, and while they are varied in the type of risks they present, they each share a common element: they are incredibly complex issues and are extremely difficult to measure accurately as they relate to the stock market. Circling back around to behavioral finance, research has found that because such risks are difficult to isolate and measure, investors ignore the risks in favor of, you guessed it, the prevailing trend, simply because it’s easier and it supports their comfortable worldview. Unfortunately, ignoring risk because it’s easier is not a strategy that is likely to end well. Just ask anyone who bought a house in ’05-’06.

Buying the dip can result in picking up a good bargain, but before you do, make sure you’ve considered the following questions:

  1. Besides “the dip”, why do I think this is a good time to buy?
  2. What kind of risk exists in my portfolio right now?
  3. How much risk will I be adding to my portfolio by buying this dip?
  4. How will I respond to new developments in the stock market, economy, or geopolitical landscape that will significantly impact my portfolio? In other words, do I have an exit strategy as well as an entry point?

After doing so, you might find that you haven’t discovered such a great deal after all.

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September 21, 2017

 

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Moving beyond the irrational

This is a guest post by Mike Wagner, analyst for D. Scott Neal, Inc., written as part of his end-of-day  analysis of markets and securities on January 20, 2017, reflecting on the inauguration of Donald J. Trump as the 45th President of  the United States. Following his astute analysis of the day’s volatility, he wrote to me:

I have ruminated on today’s events for much of the afternoon. I seem to be caught between those who think the world stopped spinning at noon today and those who believe it began spinning again after an eight-year hiatus. Maybe it is an appropriate irony, then, I have so little to say on such a momentous day. It struck me while looking at the day’s volatility how incredible it is that in such a divided country a peaceful transition of power could occur even still. Our financial markets function still; our communications function still; save for a small few who will take absolutely any opportunity to loot and burn, our streets remain free of other-than-usual violence still; in short, the Republic survives.

I think back to my freshman year at the University of Kentucky when, for a history class, I spent the afternoon in Special Collections breathlessly reading and re-reading the 1942 speech H.L. Donovan, then-president of the University, gave in response to America’s entry into the Second World War and the University’s role in the same. He spoke with great eloquence of the sacrifices that victory in that conflict would require, noting that the country had discovered it could not have the flying fortresses, ships, tanks, guns, and other supplies necessary to successfully wage war without giving up many of the comforts and conveniences of everyday life. I wonder what sacrifices might be required for this freedom of ours to continue through what feel to be very troubled times. I wonder also what sacrifices I have ever had to offer for the enjoyment of this democracy, if, indeed, I have offered any. Reading the letter quoted by Senator Schumer during this morning’s inauguration proceedings of one Major Sullivan Ballou to his soon-to-be widow leads me to wonder who indeed loves democracy in its ideal as opposed to loving it only insofar as its abstract supports the particular philosophies to which one may subscribe?

These questions make exceedingly poor market analysis, I grant, but their answers, at present, lend me the same conclusion I have of the market itself on a day like today: I don’t know. No one, of course, knows what the market is going to do. That said, much of the work we do here ultimately rests on the premise that there is a psychology to the market crowd which might be irrational itself but which may be rationed through nonetheless, ultimately giving some sense of clarity. I find myself to be remarkably unclear at the moment, despite the felicity of the Elder signals. So, for tonight, I’ll close with a simple but sincere prayer: God help us.