Field of play
A wall of worry
Since I began investing in the stock market fifty years ago, scarcely a day has passed when our local business newspaper (Canada’s largest and most influential) has not contained articles about worrying conditions in the economy and stock market.
There is an old Wall Street adage, apparently from the 1950s, that tells us, stock bull markets climb a “wall of worry”. That may be true. But it is also true that the stock market constantly faces a wall of worry; in bull markets, in bear markets, in sideways markets and in bubbles.
Since I have been investing in the stock market, I think I can also say, analysts and pundits have constantly said that the stock market is richly valued, overpriced and ready to take a tumble. These two sentiments, worry and overpriced, combine to suggest heightened risk in stock markets, everywhere and all the time.
In this post I propose to describe and explain what I see as the four faces of risk in the stock market. These are low risk, medium risk, high risk and crazy high risk.
Four faces of risk
In a world of constant worry and constant uncertainty, thoughts about risk are often a matter of perception.
In a down market
Let’s start by looking at perceptions of risk in down markets, i.e. in bear markets. We will then go on to look at perceptions of risk in markets that are not moving either strongly down or strongly up. Next, we will look at perceptions of risk in bull markets. Finally, we will look at perceptions of risk in bubbles.
A representative of a savings-and-loan company came to Benjamin Graham with several questions.
“The first question he asked me was: “Don’t you think that common stocks are now are less safe than before because of the decline in the market?” That hit me between the eyes. Here were financial people who could seriously consider that stocks were less safe because they have declined in price than they were after they had advanced in price. “(Graham, 1973 The Intelligent Investor, fourth revised edition.) p.10 (emphasis added)
Graham’s point is that stocks in general, and any given stock, are no more risky when prices have declined, and probably less risky. I ask the reader to ponder whether stocks were more or less risky in January 2009 at the depths of the Financial Crisis bear market? The answer is that they were less risky. There were some extraordinary bargains available at that time. I bought shares in a mining company at that time for less that the cash held by the company. The productive mines were thrown in for free. Investors were scared that the company would spend the cash on some bad project. In early 2009 I was able to buy shares in Canada’s largest bank for a modest fraction of its tangible assets per share. Canadian banks were not caught up in the sub-prime crisis. Up to the point I bought these shares I had never seen a Canadian bank selling below tangible book value. It seemed to me at the time that stocks had become less risky in early 2009 than they were six months earlier.
And yet, the worry and uncertainty were palpable at that time.
Howard Marks is Co-chairman and Co-founder of Oaktree Capital Management, a Los Angeles-based investment firm. He has a finance degree from Wharton and an MBA from the University of Chicago. He is the author of The most important thing illuminated – Uncommon Sense for Thoughtful Investors published in 2013. (Marks, 2013) He has a wonderful expression, perversity of risk, to describe risks going down in down markets and up in up markets. He writes: “Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.” (Marks, 2013) p68 (Emphasis added)
My conclusion from this is that, perversely, perceptions of risk increase as prices go down. Worry and uncertainty abound, as they do all the time. But, in a down market, a bear market, risks actually go down. This is a good example of groupthink and herding with general risk aversion.
In a sideways market
The stock market doesn’t actually go sideways, but let’s use that word anyway to distinguish it from bull and bear markets and bubbles. Over the long haul a chart of stock prices slopes up to the right. This is because over the long-haul stocks create value for their shareholders. This is illustrated in Figure 1-4 from Jeremy Siegel’s book 1988 Stocks for the Long Run – The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies. Stocks are the upper line. Bond and T-Bills are below, with gold and the dollar at the bottom. The chart shows real (after inflation) total returns from these different assets.
So, a sideways market is actually sloping up gently to the right. Within the overall slope, there is volatility which represents bull and bear market and also bubbles. For our present discussion, let’s simply say that a sideways market is all market conditions other than bull markets, bear markets and bubbles.
It has been my observation over the years that worry and uncertainty exist at all times in a sideways market. There is never a time in sideways markets when there is not constant worry about the economy, monetary conditions, inflation, deflation, disinflation, interest rates, stock valuations, wars, pestilence, migrations, geopolitical tensions, nuclear threats, climate change, food shortages, fires and floods.
In a sideways market there is always risk and a perception of risk in common stocks. There is always a wall of worry. Hence, we have the equity risk premium. That is, common stock investors earn a premium over so-called risk-free assets because of the perception that stocks are more risky.
Bull markets
Bull markets are also said to climb a wall of worry. In spite of fears and worries, a bull market feeds on itself. Bull markets rise out of sideways markets. In spite of all the worries, they are not initially especially risky. Risk increases through a bull market even as perceptions of risk decrease.
Let us reflect on some of the factors that are at work in the real world as a bull market unfolds. There is nothing new here.
Gerald Loeb’s book, The Battle for Investment Survival, was published in 1935 and was the most popular book on investing written for individual investors for at least the next twenty-five years. (Loeb, 1935, 2007) Loeb was a stockbroker. He joined E.F. Hutton in 1924. Through the 1960’s he was one of the best known and most often quoted figures on Wall Street. The first edition of his book sold 250,000 copies. It was republished time and again, most recently in 2007.
The Battle for Investment Survival was written at a time when investors were still licking their wounds from the terrifying stock market rout that began in 1929 and most were still suffering the effects of the Great Depression. Today, investors’ memories are still seared by the stock market turmoil of 2008 and many continue to be affected by the Great Recession that followed. Loeb’s book was written in a different age but there is much timeless wisdom in what he says and the style of writing is very approachable. Some of what he writes I disagree with. He is conflicted. As a broker his income depended on commissions. But there is also much sound advice.
Loeb wrote about the forces behind market swings: “Market conditions are fixed only in part by balance sheets and income statements; much more by the hopes and fears of humanity; by greed, ambition, acts of God, invention, financial stress and strain, weather, discovery, fashion, and numberless other causes impossible to be listed without omission.” He adds, “Even the price of a stock at a given moment is a potential influence in fixing its subsequent market value. Thus, a low figure might frighten holders into selling, deter prospective purchasers, or attract bargain seekers. A high figure has equally varying effects on subsequent quotations.” (Loeb, The Battle for Investment Survival. 1935, 2007) p2 (emphasis added)
What Loeb is talking about is not interest rates or expectations for profits. He is talking about the behavior of investors as human beings.
In 1937, Keynes wrote in The General Theory of Employment, published in Economic Journal, 51, 2 (1937), p.214, as quoted by Niall Ferguson: “(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words, we largely ignore the prospect of future changes about the actual character of which we know nothing. (2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects… (3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average.” (Ferguson, The Ascent of Money – A Financial History of The World. 2008) p344 (emphasis added)
For an example of how investor confidence ebbs and flows we can turn to Peter Lynch who wrote: “For two decades after the Crash [of 1929], stocks were regarded as gambling by a majority of the population, and this impression wasn’t fully revised until the late 1960s when stocks once again were embraced as investments, but in an overvalued market that made most stocks very risky. Historically, stocks are embraced as investments or dismissed as gambles in routine and circular fashion, and usually at the wrong times. Stocks are most likely to be accepted as prudent at the moment they’re not.” (Lynch, One Up on Wall Street. 1989,1990) p59 (emphasis added)
Warren Buffett is reported to have told Congress on June 2, 2010: “Rising prices are a narcotic that affects the reasoning power up and down the line.” (Marks, 2013)p.101 (emphasis added)
The bottom line in a bull market is that, over time, stocks become more risky as prices move away from fair value due to the narcotic effect. But, per Peter Lynch, the face of risk in a bull market is that “Stocks are most likely to be accepted as prudent at the moment they’re not.”
As a bull market progresses, the economic climate becomes more benign and then becomes heated. What is interesting is that when the economy enters the heated phase, most investors think the world has finally returned to normal i.e. not overheated. Fear and worries recede, not entirely, but substantially.
That is, risk increases through a bull market even as perceptions of risk decrease. This is a good example of groupthink and herding with general risk seeking behavior.
Bubbles
Bubbles are an entirely different kettle of fish.
Bubbles represent a problem that is outside the bounds of normal stock market volatility. True stock market bubbles may occur only a handful of times in a century. When they occur the normal rules of the game go out the window.
It’s easy enough to say that in a bubble prices get dramatically out of touch with reality. But what really is a bubble? ‘Irrational exuberance’ was the expression used by Alan Greenspan in late 1996 to describe the Dot Com stock market as it built to its 2000 peak. I think that expression is a bit too tame. Humans are not fully rational at the best of times. Much of the normal year-by-year volatility of the stock market is caused by ‘irrational exuberance’ and ‘irrational anxiety’. I think the term coined by Charles Mackay in 1841, ‘madness of crowds’ is more appropriate. Bubbles are true madness.
We are used to stormy stock market conditions and a certain amount of turbulence. We frequently have to batten down the hatches when the usual storms hit. Then we come to realize a different kind of phenomenon entirely is on us. It is a hurricane. I think the contrast between a summer storm and a hurricane is a really good metaphor for contrasting normal stock market volatility and true bubbles.
I have experienced two generalized stock market bubbles: the Nifty Fifty market of the late 1960s and the Dot Com bubble of the late 1990s. I also experienced the gold bubble of the 1970s and Japan’s bubble of the 1980s which was both a stock bubble and a real estate bubble. I tried shorting the Japanese stock bubble but it didn’t work out.
Pundits often declare we are in a bubble. Since I started investing, hundreds of bubbles have been declared. Only a few are real bubbles. Many declared bubbles are really silliness around a sector or theme or even an individual stock
A lot has been written about bubbles. They are a feature of life and the successful investor is well advised to try to understand them and accommodate them in their overall strategy. It is a fact of life that some the best brains of Wall Street will periodically drive off a cliff in bubbles. They act like Panurge’s sheep.
Justine Fox tells us that Panurge was a character from Rabelais’s satirical Gargantua and Pantagruel novels, who got a flock of sheep to jump off a ship by throwing the lead ram overboard. (Fox, The Myth of the Rational Market, A History of Risk, Reward, and Delusion on Wall Street. 2009) p7
The interesting thing about true generalized stock market bubbles is that most investors know full well a bubble is under way. But they can’t bring themselves to get out of the market for fear of missing out. A greater fool mentality sets in.
One of the issues I have wrestled with over the years as an investor is the question of what to do about bubbles. A policy of buying with a margin of safety for the long haul and riding out the roller coaster ride the stock market regularly dishes up through bear markets, sideways markets and bull markets, generally serves well. But bubbles are sui generis.
I am convinced that a different approach is needed for bubbles. I have come to the view that the best policy to deal with true generalized stock bubbles is to go to cash once a bubble is fully developed and stay in cash until the excesses of the bubble have been wrung out of the market. I went to two-year bonds in late 1998 and did not return to stocks until late 2002. It was the right decision.
Conclusion
Worry and fear are a constant in stock market investing. Worries are present in bear markets, sideways markets, bull markets, bear market and even in bubbles. Risk is lowest in bear markets. It is moderate in sideways markets. It rises in bull markets. It soars in bubbles.
Ironically, the four faces of risk reverse actual risk. Risk is perceived to be highest in bear markets; moderate in sideways markets; increasingly lower in bull markets; and, more or less ignored, in bubbles.
My investment process keeps me invested 100% in stocks throughout bear markets, sideways markets and bull markets. I go to near cash in the late stages of bubbles.
For what its worth, it will come as no surprise, I think we are in a bull market today.
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Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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