2020 is almost over. The end of the year often means strange-acting markets. This is because liquidity is low, as most people just want to chill out with their families. In non-2020 “normal” years, many money managers start checking out around Dec. 15. They head for ski slopes, beach villas, or other lavish non-workplaces. Despite being an obviously non-normal year, the last few days of December are still not indicative of usual stock-market behavior.
This week, we won’t go over what big money is doing like we usually do because data is less reliable opposed to January, when things rev up again. Instead, I want to discuss a timeless theme, especially essential with a new year ahead.
We’re humans with wants, needs, dreams, and fears. We laugh, cry, love and hate. It’s inescapable: We’re emotional beings.Â Emotions make us both great and awful. They help create art, literature, and music.Â Emotions fuel love stories, but also wars. Emotions are the foundation of our human experience. They are merely electrochemical responses to our perceptions of the world around us. They are also viral. This being the year of viral contagion, let’s explore emotional contagion â€“ more importantly: how to avoid its trappings in 2021.
Either in a group or one-on-one, we can “catch” emotions. Evolution tells us that we are social creatures who survived in groups. Picking up on fear helped us survive thousands of years ago. Picking up on admiration helped us follow leaders. One might think evolution rid us of our reliance on emotion, but despite our technological advances, we’re still just inherently cavepeople.
This was proven again in 2014: Facebook, Inc. (FB) and Cornell University conducted a massive experiment on nearly 700,00 people. They reduced emotional content in news feeds.Â In short, when positive content was reduced in news feeds, users produced less positive and more negative posts. The opposite held true, too.Â
Emotional contagion is real, and we are deeply hard-wired to it even if we donâ€™t realize it. I found decades ago that I am deeply susceptible. I tried trading on my emotions and got my hat handed to me. When people got bullish, I bought the top. When they got bearish, I sold the bottom. It was a disaster. So, I developed a system to help me conquer emotion by removing it completely. It did wonders for my investing.
Recently, I was chatting with a few old Wall street colleagues. Once upon a time, they were either my clients, bosses, or employees. “Streeters” know that emotion is the enemy of investing. Something coincidental emerged in our chats. The market is overbought but could stay that way. Therefore, bullishness is excessive, but prices could rise further. Each day the market seems to defy gravity, and prices are moon-bound. But invariably a sell-day comes.
- One quant-minded guy remarked: “I notice youâ€™re cheery when your portfolio is having a big green day, and decidedly less so when the market is down.”
- Another guy who has literally made millions in the market straight up said: “I don’t like down days.”
- A third guy said: “I like to look at my account when there’s green.”
Those comments seem so obvious that I thought: What if I could create an emotion indicator? It had to be sophisticated. It had to be accurate, and it had to be quantitative â€¦ So, I spent time, and this is what I came up with based on years of observations and experience. This is how emotion looks when overlaid against a price chart:
To quote Homer Simpson: “It’s funny because it’s true.” When we are losing money, we get negative. We feel cheery when we win.Â Multiply that times millions of investors and trillions of dollars, and you get a very big cauldron of emotional contagion.
When emotions hit extremes, our internal survival mechanism tells us to act. When markets look fearsome, instinct tells us to sell and protect our stash. When markets are excited, instinct tells us not to miss out.
We now know that these emotional responses can be a cruel betrayal. At my research firm, we observed that, when emotions get extreme, the opposite action is usually the appropriate one â€“ according to our 30-year backtested history. Just looking at this year’s Big Money Index, we see it in action:
Notice that, when Big Money started to exit stocks in January, emotion was very bullish. It continued until late February. Then the runway ran out, and off the cliff we went. In late March, sentiment was about as low as we could go. Negativity persisted for months, but Big Money started buying just as gloom peaked. Eventually sentiment turned optimistic again, with signs of non-cataclysmic economic activity and a new election. Positivity peaked in September, but Big Money exited well before. As sentiment returned negative, look how Big Money started buying as the election results were close to conclusion. Now, we are back to ebullient sentiment: a vaccine is coming, the world will reopen, and life will return to normal.
This year’s history alone tells us that we should watch for when Big Money exits, not when people start to feel bearish. The odds are that, when they do, we should buy. By the way, it’s not just this year. I have decades of data evidence. While not always true, it is mostly true.
2021 will bring new opportunity. I urge you investors not to fall victim to emotional contagion. When everyone is bullish, perhaps you should be cautious. When everyone is bearish, maybe you should be bold.
Warren Buffett figured this out ages ago: “Be fearful when others are greedy and greedy when others are fearful.”
The Bottom Line
We (MAPsignals) are bullish on high-quality U.S. equities in the long term, and we see market pullbacks as areas to pick up great companies.Â
Disclosure: At the time of publication, the author holds no positions in the securities mentioned.