Outlook: The bear in our minds
NEW YORK. 05:00 AM EDT—Could the correction in the technology sector deteriorate into a full-blown bear market?
The answer, uncomfortable though it may be, is yes.
Tech stocks are now in what many analysts consider a full-blown correction. The most widely quoted gauge of the tech sector, the Nasdaq Composite Index, is down some 10.4% since it peaked on July 16. Any downturn of 10% or more is regarded as a correction, while a steeper decline of 20% or more would typically herald a bear market.
As soon as stocks begin to drop, Wall Street firms suddenly seem compelled to take on the role of therapists, telling their clients that there's no reason to worry. A market decline isn't bad at all; it's simply a "buying opportunity" that should enrich cool-headed investors even more.
Brokers-cum-therapists point out that the world has changed dramatically since the great crash of 1929, even since the last collapse in 1987. For one thing, they say, the government has curbed the widespread use of margin loans to buy stocks, one of the chief culprits of the 1929 crash. Since the 1987 crash, the use of computerized selling programs has also been restricted. What's more, stocks are benefiting from a Goldilocks economy with strong growth and low inflation.
But the truth is, the threat of a meltdown in stocks can never be eradicated. In fact, the argument that stocks can't crash is in itself the most persuasive case against strong market gains. At the heart of investing is the simple idea that people who take risks will be rewarded.
We like to think that we live in an era of great stability, but financial crises aren't dead. They can still wipe out investors overnight. Just two years after the 1987 crash, Japan's stock market bubble collapsed. Europe's exchange-rate mechanism buckled in 1992 and 1993. The bond market crashed in 1994--the same year that the Mexican crisis forced the U.S. to bail out its southern neighbor. East Asia went into total economic turmoil in 1997. And Russia's debt default happened as late as last year.
As long as human beings with fears and hopes buy and sell financial securities, there will always be a risk of steep market declines, says John Schott, a psychiatrist who teaches at Harvard Medical School and also comanages client portfolios for Steinberg Global Asset Management.
Schott, who publishes a newsletter on market psychology, says this stock market shares many of the characteristics of a manic-depressive person. Over the last few years, the market has gone through a hyper-maniacal period, he says. The problem is that this bullish period is setting the stage for a traumatic setback for the market.
Schott thinks there's a good chance the market will soon plunge the way it did in 1987. "In fact, a crash now would probably be worse because the buying power is concentrated in fewer hands," he says.
Contrary to popular belief, the stock market is not a bazaar dominated by individual investors trading stocks over the Internet. In the 1960s about 85% of stocks were owned by individuals. But with the advance of mutual funds that share has dropped to about 25%, and will likely shrink even further. And the institutional investors--there are about 2,000 of them--are no less prone to psychological swings than people who invest in their own portfolios, Schott says.
In the long term, stock prices are determined by fundamental valuation, according to Sam Hayes, a colleague of Schott's at the Harvard Business School. Stocks have historically appreciated because of rising earnings projections, he says. Companies have become more profitable by growing their top line, which in turn trickles down to the bottom line, and by becoming more efficient and productive. This trend is likely to continue in the future as the economy expands and demand rises.
But in the short term, stock prices are determined by liquidity. As long as there are more buyers than sellers, the market will continue to rise. When the market reaches a watershed and sellers suddenly outnumber buyers, market psychology could lead to a crisis.
Let's say that the market drops sharply in one session. This will shake up nerves among investors, but many will shrug off the decline as an anomaly. Then, the next day, another dramatic setback takes place. Now the initial nervousness will increasingly turn to panic. Suddenly, the mind-numbing gains of yesteryear don't seem like such a sure thing anymore. More jittery investors will try to cut their losses and sell off their stocks.
As the snowball rolls, the panic will spread even further. Desperate investors will begin to fear that they will lose everything they own--although in reality, of course, no market crash will ever wipe out stocks completely. Investors who thought they were in the market for the long term--and this includes people who have put their retirement money in 401(k) accounts--will begin to liquidate their portfolios.
In the middle of this rubble, some remarkably composed and self-possessed individuals will begin to buy stocks on the cheap.
"I remember John Templeton told me he had made a bid of companies he would have liked to buy if it weren't for the fact that they were too expensive. Then the market crash happened in 1987, and he found that many of those companies were being sold at bargain prices. He placed some really low bids and was able to buy the stocks on the list on the cheap," says Schott.
But people like Templeton, the legendary founder of the Templeton Growth Fund, represent a tiny minority of investors. Loath though we may be to admit it, few of us possess the ice-lined stomachs to act with such singular determination and rationality during a market panic.
Why do investors panic? The answer, Schott thinks, is found in the nature of human beings.
As early as the eighteenth century, Dutch mathematician Daniel Bernoulli found that humans are naturally risk averse. Bernoulli found that people value what they already have much higher than what they could potentially gain in the future.
Modern-day scholars, including University of Chicago economics professor Richard Thaler, have confirmed Bernoulli's findings. The typical person they have found experiences the pain from losses about twice as keenly as he feels the pleasure from gains.
At the same time, humans are social beings who are prone to act in herds. Most people naturally feel most comfortable acting in tandem with a greater community. Moreover, the majority of humans have a strong need for role models and authority figures.
Those two fundamental human traits--risk aversion and the herd mentality--form the basis of panic reactions. For most of us, the only way to avoid being caught in the market's maelstrom when a panic sets in is to act contrary to our own instincts.
"It takes patience, discipline and courage to follow the contrarian route to investment success: to buy when others are despondently selling, to sell when others are avidly buying," John Templeton once said.
Wise words not just in a market panic, but in the heady days of a bullish surge as well.
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