The Cocktail Party Indicator

Sunday, May 1, 2011

“No study of man can succeed unless the heart has a part in it” - Humphrey B. Neill 1

 
An asset bubble can be defined as a substantial difference between an asset’s current price and its intrinsic value2. It is no secret that bubbles are a disruptive force, creating a transitory wealth effect during its ascent and severe economic hardships after it bursts. Much has been written about bubbles, often pointing to monetary and fiscal decisions that, with the benefit of hindsight, proved not to be prudent.
To understand bubbles, one needs to consider the role of investor psychology. We are emotional animals motivated by overconfidence, greed, envy, and fear. At the onset of an asset bubble, the price appreciation begins to gain mainstream attention. By the time the asset bubble begins to form, price has moved above the asset’s intrinsic value. For the retail investor, curiosity gets the better of them and as they contemplate buying, prices continue to rise. Soon, they begin to feel like they are missing out. Their co-workers, friends and neighbors appear to be making money, evidenced by exotic trips and new cars. As prices keep rising, the lure becomes irresistible. They’re hooked: they buy. This behavior feeds on itself long enough so that the rate of price appreciation becomes self-fulfilling. Forget about history; common sense has become divorced from reality. This is a new “paradigm”. We are at the height of the bubble.
 
At some point, cracks in the market begin to appear and prices start to retreat. This is the period often referred to as the slope of hope. Those dreams of becoming wealthy begin to look more like nightmares. People who have bought at any price with little to no understanding of value, begin to sell. Many are initially anchored to a certain price (their cost), which is often higher than where current prices are. Anchoring is completely irrational. They do this because it is painful to lose money as well as painful to admit being wrong. Yet, as the price continues to decline, it becomes apparent that the price they’re anchored to won’t be seen anytime soon. By this time they are frustrated, confused, angry and scared. Fear and pain make them come full circle. They didn’t care what price they paid on the way up and now they don’t care at what price they sell on the way down. After all, if the only reason you bought a stock was because it was going up, there no longer is a reason to own it once the price has fallen. The bubble has burst.
How can this be so? It seems so obvious in hindsight. We all saw it coming didn’t we? As it turns out, hindsight is not 20/20. Scientific experiments have proven that, as time elapses, our “recollection” of the events in question improves. It’s not our fault; we are hard-wired this way3.
So, if we possess innate qualities that impede our ability to act rationally, how do we avoid getting caught up in an asset bubble? The reality is that bubbles will likely continue to exist and our emotional brains will draw us to them like moths to a flame. Many of us have read the wisdom of famous investors like Warren Buffet. Sayings like “Be fearful when others are greedy and greedy when others are fearful” make perfect sense but most of us are not hard-wired like Mr. Buffet. Our brains simply won’t let us think, let alone act, like this when the time comes.
Separating emotion from fact is difficult to do. That is why it helps to be disciplined; have a fundamental basis for valuing an asset. It is critical to establish what is cheap and what is expensive before investing. When the media takes hold of an issue like housing in mid-2000, they will make it a point to weight their panel of experts towards the prevailing wisdom. The proverbial bears are seldom heard. Those lucky enough to explain the bear argument are often ridiculed. Peter Schiff during 2007 comes to mind. His warnings were met with ridicule and outright anger by the housing bulls on CNBC.
 
Another famous investor, Peter Lynch, has a great theory about when to buy and sell. It’s the “Cocktail Party Market Indicator” from Peter Lynch’s book One Up on Wall Street:
“In the first stage of an upward market – one that has been down awhile and that nobody expects to rise again – people aren’t talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, ‘I manage an equity mutual fund,’ they nod politely and wander away. If they don’t wander away, then they quickly change the subject to the Celtics game, the upcoming elections, or the weather. Soon they are talking to a nearby dentist about plaque. When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it’s likely the market is about to turn up. In stage two, after I’ve confessed what I do for a living, the new acquaintances linger a bit longer – perhaps long enough to tell me how risky the stock market is – before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market is up 15 percent from stage one, but few are paying attention. In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening. A succession of enthusiastic individuals takes me aside to ask what stocks they should buy. Even the dentist is asking me what stocks he should buy. Everybody at the party has put money into one issue or another, and they’re all discussing what’s happened. In stage four, once again they’re crowded around me – but this time it’s to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they’ve all gone up. When the neighbors tell me what to buy, and then I wish I had taken their advice, it’s a sure sign that the market has reached a top and is due for a tumble.” 4
In the span of a decade, we have experienced not one but two bubbles (the Internet bubble and the U.S. Housing bubble). How did Fed Chairmen Greenspan and Bernanke not see the bubble when it was so obvious to everyone else? The internet bubble was fueled by easy money which caused the NASDAQ-100 index to climb to the dizzying level of 5,000 in March 2000 from a mere 280 in 1992. Why did the typical home in the U.S. increase in price by an average of more than 20% per year for five years when the long-term average was a mere 3.5% per year?
More recently, we have seen cotton prices shoot up from around $.80 per pound to almost $2.20 in only seven months when it had bounced between $.40 and $.80 for many years. There was a New York Times article showing a picture of a cotton farmer, sitting stoically in front of a pile of cotton from his harvest. He had stuffed his daughter’s bedroom full of cotton, essentially hoarding it in the anticipation that cotton would continue its meteoric rise.
 
What bubbles might currently exist now? We believe there potentially is a residential real estate bubble occurring in Australia. Housing affordability is at an all-time low. Mortgage debt, as a percentage of GDP is just under 90%. To put that statistic in context, the U.S. mortgage debt topped out at approximately 70% in 2007. When will it burst? We’re not sure but we know from recent experience that these extreme valuations are unsustainable. When the perception changes “Down Under”, it will be a slippery slope of hope indeed.5
 
The next time you feel yourself getting swept up into an emotional frenzy over an asset, try and remember Peter Lynch’s cocktail party example. All that talk about getting rich by investing in the next sure thing can be as intoxicating as the host’s cranberry martinis.

References:

1 Humphrey B. Neill, The Art of Contrary Thinking (Caxton Press 1954)
2 “Market Bubbles and Investor Psychology” Vanguard Newsletter, February 2011
3 Jason Zweig, Your Money and Your Brain (Simon &Schuster 2007)
4 Peter Lynch, One Up on Wall Street (Simon &Schuster 1988)
5 Steve Keen “Debt Deflation Watch”

Mr. Anderson is an Analyst and Portfolio Manager with Ancora Advisors LLC. He will be focusing on special situations such as liquidations, bankruptcies, turnarounds and companies trading at discounts to their net cash balance. He has 11 years of experience investing in micro-cap, special situations.

 
Prior to joining Ancora, he managed a special situations portfolio for Millennium Partners in New York. Before that, Mr. Anderson spent six years at the Kellogg Group in New York. During that time, he worked in the Specialist Operations group on the floor of the New York Stock Exchange before joining the firm's proprietary trading operation. In that capacity, he was a co-portfolio manager and helped build the special situations group from a two person team to a team of seven analysts and two traders. Mr. Anderson graduated with an Honors Bachelor of Arts degree from Wilfrid Laurier University in Ontario, Canada.
 
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