Kass: Emotion Begets More Volatility

While animal spirits have risen over the past few months, I have a growing sense that the market is beginning to be overtaken by emotion and that a condition of greater volatility (which is a natural outgrowth of a complacent and almost universally upbeat consensus) might continue over the balance of the year.

Technical and sentiment warning signs are everywhere.

Technically, there are signs that momentum is flagging, small-caps have begun to underperform, financials are lagging and even some of the anointed, high-octane stocks have started to stumble.

I recognize that sentiment is an imperfect timing tool, but it reminds us (especially in an extreme) that investors are thinking alike. It is at that time that it usually pays to ask whether the prevailing optimistic consensus is too pat.

Today, most investors are confident, and there is little doubt that a consensus exists.

One respected strategist even took the optimistic view a step further last week by suggesting that investors cannot lose (i.e. not tapering is bullish but tapering also could be bullish because it will mean a stronger economy and higher earnings).

History shows that these declarations that sound too good to be true probably are too good to be true and that this sort of sentiment extreme often evolves into greater market volatility and rougher investment seas.

That said, almost every single measure of investor sentiment is in a cheery extreme. For example:

  • Investors Intelligence bears have hit the lowest percent since the April 2011 peak;
  • the AAII bears hit a low since November 2011;
  • the NAAIM weekly poll has reached the second-highest equity net exposure since 2007;
  • the CBOE 10-day put/call ratio has fallen to the second-lowest level since the September 2012 interim peak;
  • margin debt is at an all-time high; and
  • equity fund inflows have increased substantially in the last three weeks.

Increasingly, individual stocks have begun to experience routine (up and down) gaps in prices of 5%-10% (or more). It is not difficult to extrapolate these individual moves into likely greater volatility in the broader markets. The longer the market extends its advance, the higher the risk of at least a warning crack or a sudden reversal.

It is quite possible that the fear of return on capital (defined as the lack of fear to the downside and fear of missing the upside) will be replaced by the fear of return of capital (and a more concerned and even more realistic view of the downside).

Rising Emotions

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-- Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

Today's opening missive will not debate the merits of today's stock market valuations (as that will come in the days ahead) but rather address the role of emotion in the investing equation.

The emotions of both fear and greed keep us from making as much money as we should.

Warren Buffett has often written about the madness of investing crowds and why it often pays in the long run to be a contrarian:

  • "You can't buy what is popular and do well."
  • "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is."
  • "You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right -- and that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else."
  • "A public-opinion poll is no substitute for thought."
  • "The most common cause of low prices is pessimism -- sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer."
  • "If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."
  • And above all, let's be attentive to Buffett's observation below that applies as much to today's market as it did when he wrote this quote several decades ago: "Remember that the stock market is manic-depressive."

I have long written that the crowd usually outsmarts the remnants, but in an increasingly emotionally charged and volatile market (which demonstrates no memory from day to day) confusion reigns, and the crowd seems to bend with the emotion (and news) of the day.

What may cause rapid changes in sentiment and how should the average investor respond?

Arguably, this manic crowd behavior (manifested in the ups, downs and insane volatility that follows) is reflected in the mood swings from depression to euphoria that have been goosed and exacerbated by the media, by performance-chasing investment managers and by high-frequency trading, momentum-based strategies and levered ETFs. We must try to stay (and invest) above the hype, avoid the pressure to "get in" during vertical moves (and to sell during deep swoons) and continue to try to take advantage of the volatility served up by the robots (rather than having it sap our confidence).

Let me briefly go over three influences that we must put into perspective -- namely, the media, hedge fund managers and the quants.


"You don't realize how easy this game is until you get up in that broadcasting booth."

-- Mickey Mantle

The business media's role is to objectively and without prejudice tell the score. provide a market perspective (in describing what the market is doing and why), present other professionals' opinions of individual companies, analyze the economy, economic releases and news, and interpret government and central bank policy -- all for the purpose of improving the public's understanding of the market's influences.

But too often media coverage becomes theatre.

The media have a tendency to amplify emotion (especially to the upside!) and have a peculiar tendency to view the world as if reflected in those fun-house mirrors, with the relentless maw of endless outlets in need of attention-grabbing headlines.

There is rarely market news that says, "Things aren't so bad, but they're not great either."

The media are too often positively biased (though there are occasionally some exceptions), and their objectivity is sometimes lost in their cheerleading and chorus of "Everything's Coming Up Roses."

Who can blame them for the use of their bully pulpit? The media have a vested interest in stocks rising; their audience (and ratings) contract in times of market downturns, and advertising suffers. If things turn really bad, their salaries and employment status may be adversely impacted. The market's theatre (sometimes of the absurd) is far more exciting when stocks are in the green rather than in the red. As a result (and almost regardless of market environment), bullish talking heads who appear in the media routinely outnumber bearish talking heads.

One should not be surprised that despite the reality of the moment and quality of future analysis, downbeat forecasts and outlooks are not what investors normally want to hear.

A little-discussed secret is that representatives (the talking heads) of significant media advertisers (print, radio and television) often appear with greater regularity than other guests. This helps to explain, in part, the media's sometimes limited criticism of glib, formerly wrong-footed bulls (names are excluded to protect the guilty!), many of whom failed to see the drop into the debt and equity abyss in 2008-2009. Compared that to the relative quickness in criticizing recently wrong-footed bears such as David Rosenberg, Nouriel Roubini, Meredith Whitney and, of course, yours truly.

Back in 1973, the first health warning appeared on cigarette packaging: "Warning -- Smoking is a Health Hazard." Perhaps in 2011 it should be legally mandated that guests/talking heads in the business media disclose that their employers are important advertisers on the platform on which they are appearing. After all, when I or anyone else mentions a stock in the media, a disclosure of ownership in my hedge fund must be made.

Hedge Fund Managers

"Wild swings in share prices have more to do with the 'lemming- like' behavior of institutional investors than with the aggregate returns of the company they own."

-- Warren Buffett

The hedge fund community has become the dominant investor over the past two decades. The rewards of differentiated performance, especially in a successful hedge fund, are huge. As a result, the performance pressures are intense. The fear of missing meaningful moves (especially to the upside) make for hedge fund catch-up buying (sometimes oblivious to overall macroeconomic strategy or individual company analysis) similar to what we might have seen over the past few months.

History shows that hedge fund managers can get even more emotional than retail investors (though there is less emotion, it seems, when markets drop).


"It's not a market. It's an HFT 'crop circle' crime scene."

-- Zero Hedge

We live in an investment backdrop that is tortured by insane volatility.

The disproportionate influence of electronic trading, high-frequency strategies (based on price momentum) and leveraged ETFs (operating in a vacuum of de-risked and inactive individual and institutional investors) corrupt the markets by exacerbating price trends (both up and down). These exaggerated moves tend to obscure any sense of fair market value at any given point in time and too often influence unduly our own investment behavior.

What Is a Proper Response to Manic Markets?

"Obviously the thing to do was to be bullish in a bull market and bearish in a bear market."

-- Edwin Lefevre (Jesse Livermore), Reminiscences of a Stock Market Operator

The game does not change and neither does human nature. So, how should the average investor respond to manic markets?

First, as I have consistently written, perma-bears and perma-bulls are attention-getters, not money-makers. When the roars of the perma-bears (within and outside of the media) sound the loudest (usually after a sharp market downturn) and/or the roars of the perma-bulls sound equally vociferous (usually after a sharp market ramp) and the fundamentals of the market and the state of the world's economies have not changed, consider buying when things look the worst and selling when things appear to be the best in the market. But, in the main, it usually pays to ignore both groups and to typically graze in between both of those extreme strategies. As to the media, listen to those in the press box and their guests playing on the field, but respond only after doing your own analysis.

Second, the investment mosaic is remarkably complex. Given that complexity and the likelihood of numerous economic outcomes, no single statement (e.g., bulls exclaiming that "stocks are good for the long run" or Cassandra clucking that "the sky is falling") should be taken seriously.

Third, even the most bullish investors should consider hedging strategies against a long book, given the tail risks from the last cycle, the structural headwinds and economic challenges (among other issues).

Fourth, even the most bearish investors should consider some long exposure, especially since stocks (regardless of the economic headwinds) are inexpensive relative to interest rates and have had a decade of neglect.

Fifth, consider professional money management (based on hard-hitting analysis and a flexible investment strategy) rather than "doing your own thing." Or at least consider a portion of your stock portfolio to be placed in professional hands, in the hands of an organization that understands your risk profile, investment objectives and has a well-defined investment process.

Sixth, if you are trading for yourself, consider a more opportunistic trading approach with your investment portfolio. As I have recently written, let the market's gyrations work in your favor -- at least until the volatility and emotion dies down.

Seventh, invest/trade with your head, not over it.

"I can't sleep" answered the nervous one.

"Why not?" asked the friend.

"I am carrying so much cotton that I can't sleep thinking about. It is wearing me out. What can I do?"

"Sell down to the sleeping point," answered the friend.

-- Edwin Lefevre, Reminiscences of a Stock Market Operator

Always maintain position size that you are comfortable with and sell down to your "sleeping point." Given the rising volatility over the past two years, keep average positions small, trade for singles, invest for doubles, and err on the side of conservatism.

Eighth, during these periods of stress, take some time off and compile an investment library and begin to read books written by investors and traders who have succeeded on the playing field and have walked the walk as opposed to those in the press box or in academia who simply talk the talk. What follows is a list of investment books I have previously recommended on Real Money Pro. You will likely learn more practical investment strategies and risk-control techniques from these investment wizards than spending a year in a Wharton classroom (and you will save $65,000 in tuition and board!).

  • Howard Marks' The Most Important Thing
  • Jim Cramer's Getting Back to Even, Stay Mad for Life: Get Rich, Stay Rich (Make Your Kids Even Richer), Mad Money: Watch TV, Get Rich, Real Money: Sane Investing in an Insane World, Confessions of a Street Addict, You Got Screwed! Why Wall Street Tanked and How You Can Prosper
  • Barry Ritholtz's Bailout Nation
  • Michael Lewis's The Big Short
  • Doyle Brunson's, Super System
  • Andrew Ross Sorkin's Too Big To Fail
  • Richard Bernstein's Navigate the Noise
  • Michael Lewitt's The Death of Capital
  • Gregory Zukerman's The Greatest Trade Ever
  • Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds
  • Edwin Lefevre's Reminiscences of a Stock Operator
  • Jeff Matthews' Pilgrimage to Omaha
  • Jeff Hirsch's Super Boom
  • Walt Deemer's Deemer on Technical Analysis (2012)
  • Jack Schwager's Market Wizards (all versions)
  • Adam Smith's The Money Game
  • George Soros's The Alchemy of Finance
  • Leon Levy's The Mind of Wall Street
  • Martin Shubik's The Uses and Methods of Gaming
  • Graham and Dodd's Security Analysis
  • Charles Raw's Do You Sincerely Want to Be Rich?
  • James Grant's Minding Mr. Market
  • Hewitt Heiserman Jr.'s It's Earnings That Count
  • Martin Mayer's The Fed
  • James Altucher's Trade Like a Hedge Fund
  • Marty Schwartz's Pit Bull
  • Robert Shiller's Irrational Exuberance

This column originally appeared on Real Money Pro at 8:31 a.m. EST on Nov. 4.

At the time of publication, Kass and/or his funds had no positions in any stocks mentioned, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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