How the Herd Is Getting This Market All Wrong -- And How You Can Profit: The Conundrum of Confidence
Having been in the investment business for 31 years now, after beginning in 1985 at legendary investment bank Drexel Burnham Lambert, having taught, coached, and guided investors and traders through the greatest bull market since the Roaring 20s, I have learned that there is one fatal flaw that is common to every human being when it comes to investing: the conundrum of confidence.
It turns out that the only place we don't like to buy things on sale is in the financial market. No one ever says, "hey, that house I love has fallen 30%, but I want to wait to buy it after it makes a new high in price," nor to we go to car dealerships and ask which cars are at all-time high prices. We are a funny species, huh?
Even our so-called experts, gurus, pundits, and, yes, Fed governors, are influenced by inputs other than objective data. Since we are all human, no matter to what level of education or length of experience, we all tend to "herd" together; and some events cause us all to herd more than usual.
There are two caveman-level causes of human behavior that have evolved from our days of battling saber tooth tigers. No, not fear and greed. Rather, pain avoidance and pleasure seeking -- and pain avoidance is dominant. That means that while trying to avoid current painful situations, pleasure is unimportant. However, while seeking pleasure, some small amounts of pain can be tolerated, until our threshold for pain is exceeded. Then, pleasure seeking is suspended until our pain avoidance actions are no longer needed. This is how we have survived long enough to reach our current humanness. But, when push comes to shove, we return to our caveman instincts, especially when our collective pain threshold is exceeded.
This monthly bar chart of I:VIX volatility index shows how we can monitor our (the collective mood of the herd we all belong to) positioning along the pendulum that swings from pain avoidance to pleasure seeking.
Click here to see the chart in a new window
I use this, along with a dozen or so others, in my Trading Room and DSE Alerts services to gauge how close the herd is to a pendulum inflection point at either end of the swing. When at the pain avoidance extreme, my objective decision support engine (DSE) generates buy signals, which take advantage of the herd's lack of confidence, and at the pleasure seeking extreme of the pendulum's path, DSE generates sell signals, which exploits the herd's extremes in confidence, creating the conundrum of the wrong action at the wrong time.
Examining the VIX chart, known as the "fear/complacency" index, depending on where the pendulum resides, the objective observation should be that when VIX is at the lower boundary of the yellow box, VIX should be coveted, and at the upper boundary, VIX should be avoided like the plague. However, history shows the exact opposite is true of we humans, whose herding instincts become unplugged when applied to financial decisions, manifesting in our grabbing for VIX at the upper boundary (right before a reversal lower) and shunning VIX at the lower boundary (right before a reversal higher). Even when we print this chart and place it on our desks, using colored flags to sell at red and buy at green, we still tend to be unable to separate the objectively indicated action from the emotional arena of financial investment and speculation.
Readers of these pages have many instances of DSE analysis on various stocks, sectors, and indices highlighting when the herd is making the same pain-avoidance or pleasure-seeking mistake that it has made historically, but still continue to follow their fight or flight instincts, only to wish they hadn't later. Don't worry: We all do it, and only those that purposefully create systems to manage these emotions have more, but not perfect, success in acting objectively.
The good news is that another opportunity is developing to avoid doing the same thing and expecting a different result. As you can see from the lower right of the chart, VIX is back to the lower boundary of the yellow box. This is where the herd becomes so fearless and complacent that we forget that the party can end, and that the hangover can be ugly. We manifest the greater fools theory in this situation, believing that there are always greater fools than ourselves out there to buy from us what we've over paid for, allowing ourselves to speculate for the sake of speculation, rather than objective analysis of risk and reward. With stocks near all-time highs, we become emboldened to keep up with the Jones' (no offense intended to those named Jones) and buy to seek the pleasure of making money, but also being part of the celebration. In other words, we herd.
Click here to see the chart in a new window
Objectively, though, this 12 +/-2 zone is historically not where confidence should be flexed, but rather where humility should be remembered. When VIX is up at the pink bubbles, confidence should be deployed, and stocks should be bought. Unfortunately, the exact opposite behaviors are seen. Again, the confidence conundrum bites hard. Those wanting to realize an outcome different than usual should consider taking an action different than usual.
---
These are the kinds of analyses we will be focusing on in our July workshop in Los Angeles, where there are still a few seats available. If you would like to reserve your spot, contact information is available at that link.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.