The market isn't a monolith. It's compiled of a vast aggregation of individual hopes, fears, concerns and perceptions, right or wrong. For today's
, we talked to a man who knows this all too well.
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Lately, investor sentiment has careened all over the place. After a surprise market rebound in January, the past few weeks have seen a pullback on growing concerns about the outlook for the second half of 2001. A flood of earnings warnings ushered along the recent retreat, but those announcements were compounded by what has seemed to be accompanied by a growing sense of gloom among investors.
What kind of a fickle creature is investor sentiment, and just how relevant is it? For some answers, we turned to
, who studies behavioral finance in his post as chair of the finance department at
Santa Clara University
TSC: Can you put the idea of investor sentiment in historical context? At this point, it seems pretty important -- people are saying even Alan Greenspan is weighing sentiment when planning rate cuts. How long has sentiment mattered?
That idea goes back at the very least to
economist John Maynard Keynes. The notion of Keynes was that sentiment can become so negative that the economy can grind to a halt, and in those situations he said the government has a very important role in starting the economy again by creating jobs, as we did here during the Depression.
The idea is that when people decide that the economy's going down and times are bad, they respond to that sentiment by doing real things like refraining from consumption, which tends to fulfill that prophecy. When there's less demand, factories close, people get laid off. The multiplier effect as we know it might well plunge the economy into recession. So the idea might well be valid.
Today, the Michigan consumer sentiment measure is one of the leading indicators that make up the leading indicator composite. It has found itself
a part of economic orthodoxy. And we know that consumer confidence or sentiment does in fact predict consumption a month ahead, so it seems there is a relationship there between how people feel about the economy and what they do. So sentiment does affect the real economy.
TSC: When you compare the situation today to the past, there's a lot more media coverage of financial news. Do you think it's possible that the media focuses too much on economic worries and actually makes things worse?
For some journalists, there's the idea that we are just reporting the news, we don't make it. But of course, sentiment spreads by contagion. People observe their immediate surroundings and get a sense of how the economy is. But the media provides what seems like a much broader picture of the economy. So without assigning any blame, I think the media's trying to do its service, which is to report, to inform people. But in the process of reporting the truth, they might well confirm people's sense that we are in a recession and thereby help create that.
TSC: How do you explain that sentiment has changed so much from just a few months ago, but we still have an incredibly low unemployment rate?
People look ahead and see that while they do have a job, they sense that it's less secure. So people are quite rational in looking ahead; they're fearful and rightly so. If this would come to pass, if a recession would indeed occur, they would lose their jobs -- who knows. But there's no longer that easy confidence that there are plenty of jobs, I'm in a fabulous bargaining position, if I lose this job or just don't like it, there are plenty waiting for me.
There's a very weak link between people's sentiment about the stock market and future movements in the stock market. It is in fact a negative relationship between people's bullishness and subsequent
market performance. The relationship is such that if people are bearish, that is likely to be followed by an increase in the stock market.
That's true in particular for individual investors and interestingly, for Wall Street strategists. The most naive and the most sophisticated share that feature: After the stock market has gone down, people become bearish.
A decline in the market causes people to be bearish, and if anything, bearishness precedes increases in the stock market. I can understand the first part: People extrapolate from the past, so if the market has gone down,
it seems like it will continue to go down. Why it serves as a contrary indicator, I'm not entirely sure. Maybe the market just likes to fool people.
TSC: Can you think of a historical parallel to today -- where you had a really hyped run-up, where sentiment was really hot, followed by a big decline?
You could look at the real estate market in portions of the '70s, where it looked like you could make money with no money down. There was a sense that the way to make money is through real estate, if you just buy and leverage it to the hilt, nothing can go wrong. And lots went wrong
when recession hit in the '80s. It's interesting that there was this kind of transition - the elevator to riches used to be real estate in the '70s and early '80s. From there, you saw a movement to stocks as an elevator to riches. And I think people are not quite ready to give up on stocks, and maybe they're right.
I think we have to be very, very careful with historical analogies; I think they're tossed out carelessly in the sense that we're all likely to look for analogies. The problem is, once you've figured out what you want to show - we are now at the beginning of what Japanese knew in 1989 - once you get the conclusion, all the analogies come into place, and people forget to think about the differences. So I think the major lesson I'd like to leave your readers with is that the future is hard or impossible to predict.