Who cares if markets are overvalued ?

A recent blog explaining that the S&P index is now at one of its most extreme overbought and overvalued levels since the 1920s elicited many responses.

Firstly what I found interesting was that very few people actually took issue with the basic premise that yes indeed the S&P is extremely overvalued at these levels.

The debate was more about what steps one should take, if any, when prices are at these historically very elevated levels.

The basic argument against my “defensive” stance appears to be along the lines of “I don’t care if the market is overvalued because at the first sign of trouble I will be getting out –  more or less at the top”

Historically the problem with this “plan” is that  when everybody is running for the exits at the same time only a few can make it out.

This is because many participators will be referring to the same, or very similar, levels of support and resistance and therefore when prices penetrate those levels there is often a stampede for the exits – think 1987.

What also happens on sudden falls in the stockmarkets is that people’s attitude to risk  changes in the blink of an eye.  The crowds attitude suddenly switches, in an instant, from  being “risk on” or extremely bullish to “risk off” and extremely bearish.

When this happens everybody’s first concern is to get out of risky assets and into safe assets, such as cash, irrespective of the returns either are offering. Our priorites swing  away from how to make more money to how to protect what money we still have.

This rapid change in the risk profile of a large group of  participators (for instance all those using margin debt to finance speculative positions) creates a buying vacuum which in turn leads to sudden  uncontrolled drops in the market (more sellers than buyers if you like). The market falls precipitously  as it tries to find a new equilibrium level.

It is a bit like when an aeroplane hits an air pocket. Everything seems fine then suddenly without warning the plane  drops more or less vertically.  Again think of 1987 or certain days in the 2000 and 2007 meltdowns or the more recent  “flash crashes”

When you do get a buying vacuum prices can fall dramatically 10 or 20% in very short periods of time indeed. Many long-term investors who had decided to exit on the first small drop suddenly find that “small drop” is in fact a 15% fall and now hesitate to pull the trigger and realise such  a large loss.

At this stage cognitive biases also  tend to take hold of our thinking and often the gambler’s bias  takes over which is where people are so reluctant to take a loss they are prepared to risk or gambler ever larger sums in order to try and prevent the crystallisation of that original the tendency to be prepared “double down” hoping for a rebound is a classic example.

We also have a tendency to “anchor” to the previous high prices. We now consider those to be the “correct” or “normal”  valuations and start to believe that the current much lower prices are simply a short term aberration that will shortly reverse.

These cognitive biases generally make us extremely unwilling to pull the trigger and take those initial losses that we had previously promised ourselves that we would happily swallow.

Then of course the next day the market falls a further 5%.  Now we would certainly grab yesterday’s prices with both hands, if offered them,  but it is too late. We are now even more reluctant to exit at today’s even lower prices. And so it goes on day after day. Very few private traders get out anywhere near market tops once the first fall has taken place, it is just too psychologically difficult to do so.

When you look at the way these down moves unfold from extreme overvaluations it really is quite terrifying.

We spoke in an earlier blog about the possibility of 50% falls similar to what happened in 2000 and 2007. A 50% fall in the market is equivalent to the market first dropping 25% and then dropping a further 15% before then finally dropping a further  22%.

The point is that it is very easy to say that we will exit at the first sign of trouble but bear in mind the first sign of trouble may be a precipitous down move. Also after that first 25% fall mentioned in the paragraph above all the commentators, with vested interests,  will be telling us that the market is due for a bounce, and only fools would be selling at these levels and that buy and hold is the only sensible game in town.  This re-enforces our own cognitive biases and we keep hanging on in the desperate hope of recovering our losses. Then the market takes its second leg down and falls a further 15%. Those previously bullish commentators suddenly do not sound so sure but advise us that the worst is over now. Finally the market takes its 3rd leg down and falls another 22%. Now everybody is of the opinion that the world will end and it can only get worse – so we finally and belatedly throw in the towel and sell – yes very close to the bottom !

It is a simple fact that in these big bear markets private investors do not get out at the top they almost always get out at the bottom.  In fact professional traders will tell us that one of the best signals of the bottom of a market is when the “public” finally give up, throw in the towel and exit.

This happens time and time and time  again. In every bear market were not just fighting the bear market we are fighting human psychology.

For those that have money in the bank the buying opportunities that then occur at the bottom of these bear markets are once in a decade opportunities. Sadly most participators won’t have money in the bank. They will  have money psychologically locked into a falling market and are unable no now take advantage of these once in a decade opportunities.

I repeat it is not that I believe the market is going to plunge tomorrow, simply that when it does inevitably roll over into the next bear market we will again revisit current prices and almost certainly prices significantly lower than they are today.

The really big  money making opportunities do not lay in capturing the next move up in already long in the tooth bull markets (if indeed there is even a next move up) but rather they will occur for those with spare capital held outside the market after the next bear market downturn has played out.

If you have a gunslingers mentality and think you can outdraw the market – good luck but  take care because the odds and historical precedence is most definitely not in your favour.

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