Market Psychology and Investors Sentiment ( mood of the market ) – The Driving Force Behind the markets

A friend of mine once told me Positive Attitude is the MANTRA for success.

 Now some may say being positive is good but one has to be a REALIST too. Isn’t that just COMMON SENSE or maybe not. I believe human psychology plays a very important part in whatever we do as humans. And I do mean everything relationship, business, career etc.

Let us explore this more shall we?

Most of us who operate in the market or just watch the market have witnessed the markets going UP on bad news and vice-versa. And sometimes the strength of these irrational or unexpected moves will make you want to lose all your foresight, judgement, wisdom and commonsense. You will be tempted to abandon your own view and just follow the trend.  There are some who do follow the trend. And there is nothing wrong with that. You don’t need to beat the market consensus but just profit from it.  But sometimes bucking against the market consensus does pay well in the end.  We all know that the markets have a habit of getting either too optimistic or too pessimistic and this has a lot to do with the market psychology.  

Understanding the market psychology and how it affects the markets is never easy. But you can position yourself and also profit from it by simply looking at the bigger picture and not get carried away by the market sentiment.    For example there were folks who went into the CRISIS uncertain about the future and with a very negative frame of mind (who would blame them) but there were others who went into the CRISIS knowing well that eventually things will get better and thus had a POSITIVE frame of mind. In the aftermath of the CRISIS all the evidence shows us that the later did profit from the CRISIS and are better for it.

Things are looking and getting better. Across the globe (with the exception of few countries) in general we are seeing a positive turn in the inventory, the manufacturing sector is beginning to do better, exports are doing well, businesses are beginning to spend some money, we are also seeing signs of improvement in the job markets, consumer and business confidence in the future seems to be getting better and one could say that we may have turned the corner. Having said that we may still see some mixed numbers going forward and although the overall health of the economy is getting better it is difficult to say with certainty that we are heading into a self sustaining recovery especially in the developed world until we start getting hard evidence that the private sector has started driving the growth.  But based on the current state of the global economy where we are getting more positives then negatives I think it is safe to say that there are no tell tale sign or risk of a double dip recession going forward and the global recovery is gathering momentum with Asia leading the way. As I have said before in my post titled “Coming of Age: Emerging Markets – The Next Generation of Growth Engines “. A post that I wrote in July of 2009 the party is in the Emerging markets.

There is no doubt that the policy makers have managed to avoid a Great Depression type event by not adopting an extremely tight fiscal and monetary policy. Keeping a loose fiscal and monetary policy has surely helped. But that said the overall cost of the CRISIS on the Governments has been enormous as evident from their fiscal position. Their balance sheets are too stretched and they are getting calls from all the quarters to take immediate steps to FIX it.  Although one understands that there is an immediate need to fix the balance sheet and also address the inflationary concerns by having a clearly formulated, defined and coordinated exit strategy in place. But that said the Timing will be KEY.  I believe the policy makers would like to see credible and hard evidence that that economy will keep growing on its own after the removal of the stimulus or in other words it is evident that the recovery is solid and sustainable. And this is why I believe the chances of a double dip are now becoming extremely remote.  But that said there are still many challenges that lies ahead and any policy mistake here could jeopardise the whole recovery. 

 Although policy makers have done a good job but there is a lot that could go wrong especially if they start playing politics and listening to the popular demand. We also have the general election related uncertainties especially in the UK.  Governments are facing resistance from their citizens and labour unions on the austerity program designed to cut the huge budgetary deficit as evident in countries like Greece and other parts of Europe.  For example in Britain which has seen the worst recession since the World War II people are showing little or no appetite for the shrinking of a system that takes up almost half of the national economic output which is far greater than that of Greece, Portugal or Spain.  And all the political parties are mindful of that. So it is hard to envisage a situation where any government trying to come to power will promise the market a severe cut in the overall public spending and take radical steps to reduce the budget deficit even if they know that the markets may punish them for their inaction.

We are already seeing that European governments are taking decisions that are mostly political by design and targeted towards pleasing their own local electorate as evident from the stance taken by the German Chancellor Angela Merkel on Greece and the EU.  The message from the German Chancellor couldn’t be any clearer. It looks like if the EU nations want a currency Union with Germany then they will have to implement economic and budgetary changes and maintain a good fiscal discipline that brings their performance into alignment with Germany. Which is probably as a fair expectation but although the German proposal especially on Greece was approved by the EU countries however, it does make the future of European Union look somewhat uncertain and also undermines the common currency. No wonder why some the recent statements of the German Chancellor have been received with horror in most parts of Europe. But that said there is a merit in the German proposal especially if you look at how the EU has failed to supervise and monitor Greece effectively. At least with the IMF involvement and it playing an important role the markets should get some comfort knowing well that it will now be extremely hard for the Greek government to misrepresent the figures going forward and there will be independent supervision of the reforms and cuts proposed by the Greek Government. So a combined EU and IMF solution for Greece albeit perceived as political by the market may turn out to be a much better solution than the initial proposal.  

However, there is a genuine fear in the market that since Greece was not guaranteed explicitly by the EU there is a strong chance that Portugal , Spain or Italy won’t be helped either.  And if the EU is unable to fix its own problem or find an EU based solution for an EU problem then it surely reflects badly on the credibility of the whole European Union and undermines the common currency.  Also if the IMF decides to create a deeper austerity program for specific EU nations this may have a negative effect on the overall demand within the Euro Zone.  Which can’t be good for the German export industry but we will have to wait and see.  It is important to point out that to its credit IMF has shown a lot of flexibility when dealing with governments during this CRISIS so one can hope that we may see a sensible plan and in case of Greece they may even agree to the Greek austerity plan created by the Government.  But there is no doubt that speculators would surely try to benefit from this uncertainty by testing the market.

On the other hand we have seen the US dollar benefit on the back of the uncertainty in the EU and also the improving economic conditions in the United States. Central bankers (especially in Asia) and investors who were reluctant to buy US dollar few months ago have all of a sudden found a renewed attraction to the currency.  We have been long on USD and I am glad to say that our bets against EURO and British pound have paid off.  The reality is there is still a dark cloud of uncertainty hanging over Euro Zone and the UK which won’t help the EURO or the pound in short term and It is also very plausible that FED may start raising rates as early as third quarter of 2010 while ECB and Bank of England may have to wait a little longer.  And to add to that the upcoming elections especially in the UK are not going to help the situation. Having said that one could see the merit in the case for British Pound being undervalued especially against EURO, however, it will be hard to find a backer for British pound in the market.  But I believe a cheap pound is a blessing in disguise and it could in fact help the UK economy going forward. Although some in the markets may still hate the UK but we have had a different view based on common sense and reality. I am glad the market in now paying a lot of attention to the UK job story which I have been watching for the past six to eight months.  Here is an extract copy of the e-mail that I wrote to a dear friend ( I have edited the content and removed his name for obvious reason ) on the 20^th of January 2010. I thought it will be an interesting read.

 << Hi D,

 Hope you are well.

Picking up from our last conversation on the status of the UK economy I thought I’ll share with you and also get your thoughts on a piece that I am in the process of writing regarding the UK economy. I think bucking against the market consensus does pay well sometimes. We were expecting some positives numbers from the UK and I am glad that is what we got.

 The Market probably still hates the UK and I can  understand the reasons for it but the market does have a  reputation of getting it wrong ( sometimes ) because we  as  people  do tend to get carried away and discounting  UK will be losing out. I won’t say I am turning all bullish but yes there are plenty of opportunities to make money spread across various asset/investment class.

Going forward I believe the market will start paying attention to the Job loss numbers in the UK surprisingly the job LOSS numbers have stayed well below the market expectation unlike any other previous recession? And I believe the main reason for that has been the flexibility offered by both sides the employees and the employers. And in terms of growth, going forward we could see a market beating quarterly GDP numbers and the reasons for that is simple we simple don’t know how much spare capacity is left in the economy and the inventories are so LOW that even with the existing and basic demand you will see a pickup in growth and this could PUSH the market up.

Cheers >>

 I think it will be foolish to assume even for a second that the British economy is not in a pretty bad shape but I believe the market has been way too negative on the UK.  And we are already seeing some positive revisions in the official figures from the Government and government agencies. But that said the British pound and the economy will still be under considerable pressure for some time going forward especially because the UK economy is very closely linked to its banking sector.  According to Fitch ratings major UK banks may have to refinance more than US 448 billion of Government -backed guarantees and funding over the period of two to three years which could be a huge challenge depending on the prevailing market sentiment and this could reflect badly on the economy and the pound. What’s more the market is also very wary of UK’s budget deficit but one must add that this is not just a UK problem but today most developed countries including of the US are facing a similar challenge. 

Although one mustn’t underestimate the importance of shrinking the budget deficit to sustainable levels ASAP I think it is also important not to overlook a major problem facing all the developed economies going forward. Which I believe is a slow-motion train wreck and the governments would need to address it without further ado.  And I believe the Greek Crisis may be an early warning of troubles to come. The governments around the world especially in the developed world who are committed to providing very generous pensions over an extended period of time will now be pressed by the markets to re-examine or re-visit their pension program.

To get a perspective let us look at some of pension obligations of the developed world. According to a research recently published by Washington based Cato Institute if the Greek government was to bring its pension obligation on to its balance sheet the government’s total debt in reality will be over 875 percent of its GDP which is over 7 times the official Greek Government debt level.  And France for example will see its total debt rise to over 549 percent of its GDP, Germany will see it total debt soar to over 419 percent of its GDP from the current level of just around 69 percent, and the US total debt will rise to over 500 percent of its GDP.  There are some economists who would argue that having the pension obligations on balance sheet is the correct and appropriate way to assess a country’s total indebtedness.  To service and fully fund these pension obligations countries (especially in Europe ) will have to aside at least 7 to 8 percent of its GDP which seems like an impossible task and not practical to say the least but I think it is important to add that United Kingdom has the most favourable demographic developments among other in the EU.

There is an immediate need to fix this hole. And unfortunately there is no silver bullet the solution will have to be a right combination of higher taxes, benefit reduction, and increase in the retirement age among other measures. Some countries have already started raising retirement age but that alone won’t be enough. There has to be a reality check and going forward we may see generous pensions scheme being shut.  Some pensioners have already found a solution by choosing to retire in emerging countries with a relatively low cost of living. And this could be a part of the overall solution.

Americans, Europeans and others living in the developed world are already buying a record number of second homes in developing markets although some of these second homes could classify as investment but some are genuine second homes so may be the government and the pension funds in the developed world could create and promote “ Retire in your second home initiative”. But for that to happen there will be a need to commit to provide and deliver the entire essential and necessary services and this will require investment in infrastructure and other assets to raise the living standards attractive enough for people to retire with comfort.  These assets could be co-owned and funded by governments and pension fund in the developed world in partnership with their counterparties in the developing world especially in Africa and Latin American countries which are seeing a steady decline in the population and are in serious need for investment in infrastructure and other areas to improve the living standards of the population.  Though this may not solve the problem but it could be part of the combined solution and will surely reduce the burden and stress on the entire system.

The reality is going forward the tax payers may not be able to take any additional burden and lenders no longer willing to fund the excessive borrowings. Going forward the markets would require and expect changes in government programs in order to keep financing the shortfalls.

And with regards to the market itself I am now of the opinion that just like our body the market has its own immune system which is mostly driven by confidence, investor’s sentiment and market psychology (the mood of the market). And a positive mood with a quarter of positive numbers could BOOST that immune system significantly which could translate into surprises on the UPSIDE. In other words it is similar to a doctor getting pleasantly surprised by a quick recovery made by the patient.  Also the placebo effect is well documented and I believe the positive Investors sentiment and market psychology has a similar affect on the markets. As we know Investor sentiments, confidence and market psychology do play a major role in moving the market both ways and why  shouldn’t they  after all the markets are made up of human beings and run by human beings so it will be affected by the human psychology.