- The Big Picture - http://www.ritholtz.com/blog -

Bearish yet long ?

Posted By Barry Ritholtz On December 14, 2003 @ 12:01 am In Finance | Comments Disabled

Q: How can you be bearish on the overall economy, yet exhort people to stay long? Isn’t that contradictory?

A: It comes down to recognizing a simple fact of the markets: Like all Human supply/demand driven issues, there is a large element of mob mentality involved. Recognizing the importance of what the herd is thinking, anticipating which direction they are going to trample in next, is one of the key principles of making money in the markets.

You can be “right,” and still lose money. You can be “wrong,” and dramatically outperform. I keep a book on my desk by Ned Davis Research called “Being Right or Making Money [1].” There is a lot of wisdom in that title.

My favorite example comes from the stock Amazon.com in the late ’90s. Jonathan Cohen was the internet analyst with Merrill Lynch covering the internet sector. When AMZN was in the $80s, Cohen declared the stock vastly overvalued. Meanwhile, at CIBC Oppenheimer, a relatively unknown internet analyst named Henry Blodgett was about to put a $400 price target on the AMZN stock.

Who was right? Eventually, both were, as the absurd price target was hit when the frenzied crowd rallied the stock past $400. In the dot com collapse, AMZN stock plummetted to $5.

In practice, each call was a money loser. AMZN may very well have been “fundamentally” overvalued at $80. Making that valuation call would have led you to missing a 500% move up — or Heaven forbid, being short. That call may have been abstractly “correct,” but failed to anticipate the crowd. That’s being right, but disastrously losing money.

On the other side, one must wonder about the Blodgett call. Did he really believe the company was worth $400 per share on a pure valuation basis? Was that call merely a self-promotional career move? (Blodgett eventually replaced Cohen at Merrill). Never answered was the question of whether or not a fundamental analyst was making (or should have been making) stock calls based upon expectation of crowd behavior. If that was the basis of Blodgett’s price target — which eventually became self-fulfilling prophecy — why didn’t he make the call to take profits?

Let’s use this same framework of considering the crowd, and apply it to both the economy and the stock market. This year, we have seen historically unprecedented levels of stimulus: Interest rates at 45 year lows, tax cuts, depreciating currency, capital gains cuts, massive deficit spending, a new class of lowered dividend taxes, huge increases in money supply. It is all but impossible to imagine that this amount of economic energy would not lead to a massive surge in GDP in Q3 2003.

But does this eliminate the natural business cycle? Can we engineer our way around the normal slack following a massive bubble thru government intervention? The cycle normally requires time to work off excess capacity and over investment from the last peak.

These simple economic laws are well understood. Personally, I find it hard to believe that after an 18 year Bull run, all it takes is a 2 1/2 year Bear market to reset for the next run. History belies that belief. But the crowd has come to believe that all is well, and its off to the races for another multi year Bull cycle. Why stand in their way, merely because you “know” they crowd is wrong.

Let me give you an example from another area, and see if we can apply it to the idea of the markets being a form of “mobocracy.”

Soccer is the (inter)national pastime of Europe, as well as much of the rest of the world. It’s arguably followed more closely than any sport is in the United States. Regional teams play across countries’ borders, so a combination of national pride and patriotism gets mixed into the stew. Beer is sold at stadiums, and their’s a lot of rowdy drunkenness, all in good fun.

Except when “Hooliganism [2]” takes over. Then crowd becomes a mob, and riots occur (“Und riot is und ungly ting… [3]“). People have been killed by the dozens, and injured by the 100s. Its not rationale, it doesn’t make any sense for this violence to erupt over a game; (If there was any rationality to it, perhaps the rioters would run around kicking things, not using their hands!).

But it happens with alarming frequency.

Now let’s hypothesize the following scenario: Imagine you are walking along outside a large European Soccer Stadium [4]. You hear a low rumble in the distance, which grows louder and more incessant. Crashes and broken glass can be heard. Soon, the sound is a near roar. Suddenly, clearing the corner is a churning mass of enraged fans. They are in full throat, smashing store fronts and overturning cars.

What do you do?

Your first instinct is to take cover. Duck inside someplace safe, find a cop, anything to get out of harm’s way.

What you certainly DO NOT DO is stand in the middle of the street, marveling at how utterly irrational the herd has become.

You could remain there, thinking to yourself –”Look at how silly these people are behaving. Don’t they realize they are acting without thought or any form of logic?” — although that might likely be your last pre-coma thought. After years of physical therapy, perhaps you will be able to eat without having to use a straw. (But I digress.)

The point is, you get the hell out of the way.

The Markets are the same way. The crowd mostly reads the same things, hears the same stories, thinks the same thoughts. Indeed, for most of the time, the crowd is actually right. They either don’t know or don’t care about “excess capacity utilization” or “current account balances.” Markets go higher simply because a majority of participants believe they will, and as they vote with their dollars, they collectively create a self fulfilling prophesy.

Which is why, when the crowd roars BULL, it behooves you to be long. A million cliches underlie this: “Don’t fight the tape;” The Trend is your friend.” The secret is knowing when a friendly crowd becomes an unruly mob. That’s when Hooliganism takes over. The cliche then becomes: “The Trend is your friend, til the bend in the end.”

Regardless of how much smarter you may be than the average participant –hell, than all of the participants — the crowd is much stronger than you. Even Bill Gates and George Soros combined cannot fight the buying power of everyone else.

So why fight a surefire losing battle? You can ride with the crowd, as long as you keep this in mind: You must know you are participating in a group activity; You cannot mindlessly become one of the herd. Stand apart, watch what they are doing — and think about it.

The difference between a mob and an individual is the ability to engage in self direct thought and contemplation. By thinking, and applying the right tools, you can catch most of the trend, and not get speared by the bend in the end . . .


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2003/12/bearish-yet-long/

URLs in this post:

[1] Being Right or Making Money: http://www.amazon.com/exec/obidos/ASIN/0970265115/ref=ase_thebigpictu09-20/103-3937756-4643047

[2] Hooliganism: http://www.sirc.org/publik/football_violence.html

[3] Und riot is und ungly ting…: http://www.imdb.com/title/tt0072431/quotes

[4] European Soccer Stadium: http://www.dw-world.de/english/0,3367,1446_A_969535_1_A,00.html

Copyright © 2008 The Big Picture. All rights reserved.