High Anxiety: Fear's Grip on Market Hits New Peak, Study Finds
The stock market moves in response to economic and corporate conditions and also on sentiment - how people feel about economic and corporate conditions, regardless of how conditions really are. James Paulsen, chief investment strategist at Wells Capital Management, part of Wells Fargo (WFC), has put together some nifty analysis showing the extent to which each factor guides investors' actions at which times. When do they focus on fundamentals and think with their collective head, when do they let their emotions dictate proceedings and, most important, what are the implications for the stock market?
Paulsen's starting point is an obscure measure called the Bloomberg U.S. Financial Conditions Index. Essentially, it measures "the financial markets' assessment of the probability of a crisis," he explains in a report to Wells clients.
Between 1995 and 2007, this index hovered between +1 and -3. Then it went into a death drop that took it below -12 during the 2008 crisis. Since then it has stayed mostly between 0 and -2.
Where things get particularly interesting is in Paulsen's comparison of stock market volatility and the Financial Conditions Index. He observed that there are certain times when the market is especially inclined to fall under the spell of the index. Those times tend to be when the index itself is quite high, so there is a compounding effect - investors are more disposed to let their emotions determine their actions at times when their chief emotion is fear.
The sense of crisis and the fixation on it have increased in recent years. The result is that the proportion of the movement in the market accounted for by crisis fears has reached its highest level in the 16 years for which Paulsen has data:
"Prior to 1997, movements in the crisis index explained virtually none of the variability in stock prices. There was not a very strong crisis mentality. By contrast, during the last year, changes in the crisis index have explained almost 80 percent of the daily movements in the stock market. The lost decade since the late 1990s has altered the focus from fundamentals to fear and has produced an investment class which is crisis-phobic."
A look at the accompanying chart shows that prior peaks have coincided fairly neatly with significant market bottoms, such as after the mid-2010 correction, the low after the collapse of Lehman Brothers in 2008, the end of the 2000-2003 bear market and the aftermath of the Asian financial crisis and Russian debt default in the late 1990s.
Paulsen's advice is to be aware of how emotional stock trading has become and use the awareness to avoid letting the mass angst get the better of you. The best course, in his view, is to concentrate on the fundamentals when those all around you are ignoring them:
"As long as the culture remains crisis-centric, the financial markets will likely be characterized by more frequent emotional and volatile market episodes. Investors, however, are probably best served by staying focused, not on the rolling popularized crises but rather on the underlying fundamentals and relative valuations."
Read more: