Sunday, 26 April 2020

Wall Street Vs Main Street (Part 1) - Irrational Exuberance

More than 26 million Americans have filed for unemployment aid since mid-March due to the pandemic. Data showed that US is nowhere near lifting of restrictions and the economic situation in the main street is daunting.  Oil price reached its historical low entering into negative territory when storage scarcity poses huge problem due to low demand. There is no clear sight of economic recovery in the foreseeable future. On the contrary Wall street stocks registered one of their best runs last month. Earlier this month, the market posted their best weekly performance since 1974.

Why is there such a big contrast between wall street and main street?

UPSIDE REWARD AND DOWNSIDE RISK NOT CONSIDER PROPERLY

There are many possible reasons. The most typical and the mechanical ones are emotionally-led news and optimisms which spur the stocks recovery.

Consider possible upside and downside
For instance, some of the positive news includes: stimulus from the Fed, peak of infections reached, impending discovery of a vaccine, restrictions lifted and economy reopening, or the thinking that this pandemic is just like any other plague which will be over in no time and all things back to normal. These are valid reasons for the upside.

However, at the same time, investors ought to consider the downside “what if” events.

Data showed the worst is far from over. Furthermore, there can be possibility of second wave attack and vaccine may take longer than expected to be developed. And we definitely cannot “inject disinfectant or shine ultra-violet into our body” to kill the virus. Nor can the government just allow the private sector decides and take the responsibility to open the economy when the virus is still causing rampage.

Ignorance of retail investors
Retail investors who lack in-depth knowledge and expertise are often driven by emotions resulting in herd behaviour which is always wrong. Refer to my previous post here explaining about the typical mainstream mindset. We think they can beat the market outright and definitely do not want to miss the once in a lifetime experience to buy stock.

Low bond yield
Fund managers are mostly responsible for market movements. With very low bond yield, managers is likely to influence their clients to buy into the “so-called” investment grade stocks that will give them 5-6% yield without fully explaining the risks involve. Since managers earn commissions from their investors as long as they invest, hence many do not really care if their clients suffer losses.

Risk exceeds Reward
To me, the downside risk simply far exceeds the upside rewards now, in view of the many uncertainties ahead. Imagine the world is in virtual lockdown. When was the last time this happen? Yet, forward PE estimates of Dow and S&P are over 20 with market rallying. It is evident that many stocks are still very expensive. Even if economy do re-opened, it is not as if there is a “switch” that will immediately bring “light to the room”. The cheer from Wall-street is unfounded.

To be more profound, these reasons are in my opinion are not the fundamental one causing the rally.

IRRATIONAL EXUBERANCE AND FOOLED BY RANDOMNESS

In essence, I believe the underlying reason of the disjointed reality between main street and wall street is the human nature who tends to be overconfident about themselves and the future.

Several years ago, I read a few books such as Robert Schiller “irrational Exuberance” and Nassim Taleb’s “fooled by randomness.” Refer to an article I wrote from Mr. Taleb’s book here.

Both books cited why people tend to be over-confident about their capability to win due to a random event that provides short term gain, without looking at the fundamentals that shaped long term outcomes. As a consequence of this human nature, risk taking appetite rise over time without making conservative preparations for bad outcomes!

Robert J. Schiller quoted:

“People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes."

“Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler's excitement.”

“How errors of human judgment can infect even the smartest people, thanks to overconfidence, lack of attention to details, and excessive trust in the judgments of others, stemming from a failure to understand that others are not making independent judgments but are themselves following still others—the blind leading the blind.”

Nassim Taleb quoted:
“Do not be Fooled by Randomness. There is something called Dumb Luck!” Time eliminates randomness. The longer it is, the better it reflects the reality.

“Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. One is capable of unwittingly playing Russian roulette - and calling it by some alternative “low risk” game.”

“Those who were unlucky in life in spite of their skills would eventually rise. The lucky fool might have benefited from some luck in life; over the longer run he would slowly converge to the state of a less-lucky idiot. Each one would revert to his long-term properties.”

“When I see an investor monitoring his portfolio with live prices on his cellular telephone or his PalmPilot, I smile and smile.” Too much emotions are detrimental to making logical decision.

GREED, THE WRONG MINDSET

With overconfidence and pride, comes greed. A friend of mine who is a nice guy said “let’s continue to make money as the real economy crash”. He has not considered the downside when he said this. In his mind, he is only thinking about making money, and how he can beat the market, neglecting the fact that there are equal if not more chance of him losing money.

Greed is in everyone, including me. I remember many years ago, when I was seeing unrealised profits of S$30-40k for just a single stock, and thinking that I was “above the universe” and can earn a living in stocks. I was thinking that I have an edge over the rest of pack, because I was in the industry. Of course, this is me dreaming when I rarely experience the ups and downs of the market yet. Even if I have that experience, how much real knowledge/expertise do I have in the financial system. Did I work that hard to research or read enough? Or how much failures/experiences in life do I have?... to be able to have the wisdom and patience to manage my emotions to stomach the losses, or to resist the temptations of greediness in the rally. How about my portfolio track records over time, and not just one or two or few events? As a matter of fact, years later I experience total loss when the stock price just tanked when it went into administration.

The lust of making money while everyone else loses; the self-gains to buy self-pleasure, and above all, the pride of life to be able to beat the market is just human nature. To be honest, when the crash first began in late Feb, I was quite happy and greed congested my mind. Anyway, this is the situation I had been preparing for, since several years back, when I patiently hoard cash and precious metals without being tempted to buy too many stocks, despite seeing everyone’s else equity portfolio rapidly rising. I was thinking, it finally a time when I make my "killing" in the market. 

As the weeks goes by staying at home and seeing more people died, and knowing that the poor and oppressed are suffering economic hardships, I realise that there is nothing to be proud of really. It is a sad situation, and I will be damn childish and selfish if I feel happy for the economical crash. The correct mindset should not be greed, it should be to “prepare for the worst”, while staying positive and cautiously optimistic. And if we are doing reasonably good, we must be prepared to help those in need, if we are called. 

CONCLUSION

Whether it is a V-shaped recovery with 23-24 March 2020 being the bottom, or trough to be retested, or if there will be U-shaped or W-shapes recovery, nobody knows! We can give all the reasons we want to support our foretelling, but it will be pure speculation.

We tend to think we are the guru, smarter and capable than the rest, and will beat the market. We do not want to lose out in any opportunity to make money, when in reality we are actually not managing our risk. It is in our nature to always believe the worst is over, and that tomorrow will be better. Hence stock market is irrational driven by news, emotions and exuberance. Oftentimes, it is de-linked from the actual situation on the street.

To "jump the gun" so fast, ploughing your cash into stocks so early is not clever, even if you eventually win in future. This is just dumb luck and you are fooled by randomness. Perhaps there can be a “black swan” event in which you or your loved ones losing their jobs, or getting real sick during this unprecedented time which requires a lot of money and attention. There will always be situation outside your anticipation. And if we are complacent, the event that took place will tend to be worse than expected.  

To NOT invest in anything during this time, if you have the capacity and knowledge is also not smart. You should be able to pick up good stocks which will bring good long-term returns, but must be patient and spread out the investments over time.

True investment is about managing risks and weighing rewards over a period of time.

As for me, I reckon I am not here to make a killing during the crisis to get rich. It is more like preparing for the worst and protecting the downside. I have a big family to support, with all seven of my household members heavily depending on me financially. While, I am comfortable in my financial position, we do not have backup luxury of parents’ wealth or apartments handing over to us.

Therefore, I have to be prudent. And as truthful as I write now, I do not feel “shiny” with the good situation I am in (refer to my previous post). Instead, I sincerely hope that the pandemic will end soon even if it means me not earning any money or even losing little money. Economic hardships always hit the poor and oppressed more, while the rich escapes unscathed, although not everlasting! Last but not least, my prayers extend to the weak and poor who suffer!

Stay tuned for Part 2…


5 comments:

  1. I like your point about protecting downside. We have family and dependents to think about.

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    Replies
    1. Hi Kevin, thanks. Yes, to provide for the family is first priority. Sense your good responsibility towards your family. Cheers mate.

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  2. thank you for great posts sharing your thinking which enriches others

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    Replies
    1. Hi cbd, Good sunday and stay safe and healthy. Thank you and it is really encouraging with your kind words for me to keep on writing. Not for earning money, my greatest joy is when readers feel enriched and can see more clearly.

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