When Will This All End?

It has been another tough month in the markets. I know that all of you are wondering “When will this all end?”

We have no illusions that it doesn’t feel awful today.  It feels foolish to keep money in stocks.  Recognize that these feelings are hardwired into our brains, the result of centuries of lessons of creating trends where none really exist.  Actually, the contrary is true.  Stocks are much more likely to rise in the year after they have fallen over 30%.

Behavioral finance studies confirm that people are more optimistic, and therefore more accepting of “risk” (however we define that term) when markets are moving upward, while they change and become pessimistic and more risk-adverse when markets are moving downward.  That is why people want to put money in “safe” investments now and wait until the market has recovered before coming back in.  We worry this is bad for people’s financial health.

The Fundamentals of Investing 101, if there were such a thing, would say behavior should be just reversed.  Warren Buffett and the other legendary money managers urge investors to buy when there is panic in the streets.  But that is so hard to do!

Why?  According to behavioral scientists, 80% of decision-making of all kinds, including financial decision-making, is based upon emotion.  Only 20% is based on logic.  Those numbers are too slick for us, and we believe different people have different emotion/logic ratios.  Our own experience, however, is that all of us make financial decisions based more on emotion than we would expect.

Here is where science comes in: studies have shown that the portion of the brain which reacts to financial loss is the same portion of the brain that is activated in mortal-risk situations.  This is why a loss has much more impact than a gain.

Remember, the best time to be in the stock market is the point of maximum fear, and worst time to be in it is the point of maximum optimism.  Which would you say we’re closest to now?

Let’s give our brain a little more ammunition in the tussle between emotion and analysis:

US stock markets have fallen by a historic amount and to levels not seen in years. Beyond the simple change in price, stocks have also fallen when compared to many fundamental measures. One important measure that helps evaluate stocks is the price to book value (the value of all the assets of a company less the cost of all liabilities). A wide array of companies are selling below their accounting book value. Here is a short list of larger, generally well known companies whose shares trade near or below stated book value.

Imagine, you can buy these businesses for the value of their plants, equipment and the cash on their balance sheets. In this crazy stock market environment these businesses are worth more dead than alive! We love the opportunity to buy these businesses at these prices, and if buying makes sense, selling sure doesn’t.

Fear and panic make otherwise rational people do unusual things. The unwillingness of investors to hold stocks (or buy them) at these sorts of prices makes no economic sense at all. Only when people look no farther forward than the end of their nose does this sort of fear make sense. “Everyone else is selling; I guess I better sell too!” Have you ever tried to drive to the store while only looking at the end of your nose?

This recession will end. The consensus opinion is that the actual recession will be over in the 3rd or 4th quarter of this year. Growth in the economy will resume next year. And while that is still some time away, stocks and other mis-priced assets will begin to anticipate the recovery before it actually happens.

Remember, we’ve been through this before, but each time, scary market and economic environments like this make us forget just how uncomfortable and frightening past economic downturns have been. The press doesn’t help with their single-minded focus on the worst of news. Here are some quotes from bygone days to help put this in perspective.

“Investors have been frightened of an economy that seems out of control…The stock market has scarcely been so shaky since 1929…A Gallup poll published last month found that 46% of adults feared a depression similar to the classic one of the 1930s.”  (Time Magazine, September 9, 1974)

“Falling real estate prices and the fragile state of the banking system make this recession unlike any other and extremely difficult to forecast.”  (John R. Dorfman in The Wall Street Journal, February 7, 1991)

We’ll only know in hindsight just how long this recession lasted, and how low stocks will have fallen in the current panic and financial turmoil. Do remember however that this too shall pass.

We’re always happy to hear from you.

Warm regards,

Karl Schroeder

Schroeder Financial Services, Inc.

895-0611

“Fall seven times, stand up eight” Japanese proverb