Remember one month ago, when the S&P500 (NYSE:SPY) was heading for 1500, and investors seem to think that equities are the best game in town. Now the S&P500 is heading for 1300 (losing more than 100 points), investors are running away from equities. What has changed in one month?
On the political front a lot. America has a new President and China has a new political leadership. On the economic front not much. The world macroeconomic environment continues to remain challenging, corporations report mixed results, uncle Ben is ready for another round of QE, and traders continue to debate the fiscal cliff. What can then explain, this big change in investor sentiment?
Humans are both intelligent and emotional beings. Intelligent beings decide by reason, by carefully examining the parameters of the environment they live in, setting goals and priorities and crafting alternative strategies and tactics to reach them. Intelligent consumers, for instance, carefully examine their economic situation, taking stock of their human and non-human resources, ranking and prioritizing their needs and desires—the need to be satisfied first, second, and so on—in order to derive the maximum return from their human and non-human resources, as it is taught in standard economic books.
Emotional beings decide by impulse rather than reason, fueled by anxiety, anger, fear, greed, complacency, etc., ignoring the environment they live in, failing to set goals and priorities, craft strategies and tactics. Emotional consumers, for instance, fail to take stock of their human and non-human resources, and to prioritize their needs and desires. Instead, they act out of impulse, rushing and racing to buy products filling the needs and desires of ruthless marketers, rather than their own.
The intelligent and the emotional side of human beings come out in investing. Intelligent investors make decisions by carefully examining their financial priorities and constrains, and the “economic fundamentals,” the macroeconomic and microeconomic environment that surrounds financial markets.
Emotional investors, by contrast, make decisions by impulse and hype fueled by irrational exuberance and irrational pessimism, rather than reason. They rush and race to buy or sell stocks, simply by listening to “experts,” stockbrokers, financial analysts, and portfolio managers who come up with one story or another to support an everlasting trend.
Irrational exuberance and irrational pessimism is more pronounced in momentum investing whereby investors chase after popular stocks—networking in the late 1990s like JDS Uniphase (NASDAQ:JDSU), Ciena (NASDAQ:CIEN), Cisco Systems (NASDAQ:CSCO), and Lucent-Alcatel (NYSE:ALU) that now trade at a fraction of their 2001 highs.
Emotional investors fail to separate the news from the noise, selling stocks with good and bad fundamentals alike. On Friday, for instance, investors were selling off the stock of Sears (NASDAQ:SHLD), which reported disappointing earnings, and the stock of Apple (NASDAQ:AAPL), which didn’t have any major corporate developments.
Emotional investors behave like a herd copying and replicating the behavior of one another, fearing that they will miss out on a market uptrend or be crashed in the market downtrend. They end up amassing and losing fortunes without fully realizing it.