We are only human

Behavioural economists have noted that humans do not assess gains and losses in a symmetrical manner. That is, the emotional magnitude of the pleasure of a $10,000 gain is less acute than the pain of a $10,000 loss. But due to recency bias, during raging bull markets of a long enough duration, US stock investors tend to put out of their minds a period like late 2007 through March of 2009, during which they lost roughly 50%. The sting of those losses has been replaced by what appear to be the easy and durable gains occurring over the past decade. Sure, there were bumps along the road, but nothing even totalling a 20% loss.

However, when markets enter freefall – as has occurred for the five weeks following the market’s February 19th peak, in which the S&P 500 declined an astonishing 35% (!) – this is the sort of jolt from which people sober up. The cold realization may set in that it now takes a 50+% gain just to get back to even. Under these circumstances, it would seem impossible that there would not be some damage to investors’ collective psyche. Where there had formerly been nothing but complacency and confidence, now doubt and uncertainty reside. Collectively we may begin to wonder: will things get worse, perhaps much, much worse before they get better?

Market participants are currently in the midst of a grand-scale prisoner’s dilemma in which one’s financial security is tied to whether the other participants will “defect” by exiting the market, thereby driving down share prices further. Faced with these prospects, “defection” may appear increasingly attractive, causing a cascading effect.

But there is another element to consider. In certain circumstances, fear is not only a valid emotional response, but it can be the salutary impetus for self-preservation. Walk too close to a sheer ledge with no barrier and instinctively one veers away from it lest a slight stumble lead to personal calamity.

At present, the S&P 500 is down more than 20% from its zenith just weeks ago. Nevertheless, based on historically reliable valuations measures, it is roughly as excessively valued as it was at the peak of the bubble prior to the Global Financial Crisis (GFC), during which it would lose 55% of its value.

So, if investors know that economic activity in the second quarter will contract more than at any time in modern history, does it make sense to be courageous and stay in a market that has only been more overvalued in 1929 and 2000? Or does it make more sense to use this rebound to further reduce exposure to stocks and other risk assets?

Only time will tell

Post courtesy of Niels Kaastrup-Larsen