This morning I came across an article on CNN that conveyed a bit of good news about the bull market. According to an annual Bankrate.com study, despite the fact that the market has made new all-time highs in the past few months, 73% of Americans are not currently inclined to invest in stocks.
If this statistic doesn’t strike you as particularly good news for the market, let me explain. There are two ways that most traders assess a stock or the market as a whole. The first way to assess a stock is by using fundamental analysis. Fundamental analysis of a stock focuses on “fundamental” metrics such as earnings per share (EPS), price-to-earnings ratio (P/E), and debt-to-equity ratio. The purpose of fundamental analysis is to compare the values of stocks based on one or more of literally hundreds of metrics that take into account things such as revenue, debt, share count, growth rate, and share price. The other way to assess a stock is by using technical analysis. Technical analysis of a stock focuses on the a chart of the stock’s recent share price. Technical analysts look for particular formations and indicators that show up in stock charts that are formed by movements in share price. One of the simplest technical analysis formations is a trend line, which I draw on most of the charts I post on this site.
I use both technical and fundamental analysis methods when I assess a stock, and virtually every other trader uses at least one of those two methods as well. However, there is one tool that I consider to be far more important than these approaches, and that tool is psychology. More specifically, if you have the ability to put yourself in the shoes of other traders, you can predict what they are likely to do. I’m not talking about reading people’s minds, so don’t worry if you don’t have psychic powers. All of the true psychics are already stock market billionaires anyway, right? I mean, why wouldn’t they be if they can see the future?
So since I’m not talking about telepathy, let me demonstrate what I am talking about. Let’s start back in 2008 when I bought my first stock. As I’m sure everyone is well aware, by the end of 2008 the stock market had crashed and America was in the teeth of the so-called Great Recession. Lots of people lost lots of money in stocks during that time. And you don’t have to be a psychic to guess how they were feeling at the time: angry, bitter, resentful, regretful, disenchanted, embarrassed, and most importantly terrified. They were scared of the collapse of the economy, scared they would lose even more money, scared they wouldn’t be able to retire, scared they would lose their homes. People were just plain scared, and the root of all their fears was the merciless stock market, which kept plunging day after day.
So what do scared people do when the market starts to drop? The people that are most scared sell their stocks. Sure, maybe they endure a small loss, but at least their remaining money is now safe. But the selling by that group of people causes the market to start dropping more sharply, which in turn starts to scare another group of stockholders, and the effect simply cascades from there. That pattern is the dynamic of a stock market crash. The result is the aforementioned series of emotions being felt by everyone who was burned by the market. It’s a horrible and helpless feeling to watch your hard-earned retirement money evaporate before your eyes. Obviously I didn’t experience that feeling firsthand, but I don’t have to be a psychic to imagine what someone in that position must be feeling.
But all recessions come to an end eventually, and the market cycles back from bear to bull. The bull market that has occurred during the recovery from the Great Recession has been astounding. The Dow Jones Industrial Average has risen from under 7,000 to over 16,000 in about five years. Anybody that held their investments through the whole ordeal likely came out ahead in the end. Unfortunately, the emotions I mentioned before, particularly fear, are too powerful for most people to ignore. Victims of the market crash that sold their stocks out of fear in 2008 likely didn’t buy them back in 2009 when the Dow was at 7,000. They didn’t buy back into the market later that year when the Dow hit 10,000 or in 2010 when it hit 12,000. The fear of losing your life savings, your retirement, or your child’s college fund is not the type of fear that you forget in six months or a year. The more powerful the scare, the longer the recovery.
By April of 2012, the Dow had made it above 13,000, but Bankrate’s survey indicated 76% of Americans were still skeptical. That 76% number hadn’t budged by April of 2013 when the Dow was above 14,000, and it has dropped only 3% to 73% nearly five years after the crash, even with the Dow now sitting above 16,000.
But how is that good news for investors such as myself? Remember the dynamic of a market crash: market drop leads to scared people selling, which scares more people, which leads to more people selling, and on and on until everyone is scared. As it turns out, a bull market has its own dynamic. Once the market reached its low point in early 2009 and everybody that was scared had already sold their stocks, there was nobody left to sell and the market began its recovery. A slight rise in the market encouraged the bravest sellers to begin buying back the stocks they had sold, which boosted the market higher, which lead to more people getting brave, and you get the picture. So whereas a bear market continues to fall until everyone is scared, a bull market will typically continue to rise until everyone is brave. And according to Bankrate, 73% of Americans are not yet feeling brave when it comes to the stock market.
Of course anything can happen, and if the U.S. and Russia start a nuclear war tomorrow the bull market will be over in the blink of an eye. But a survey such as this one is a positive indicator to me that, as long as the U.S. economy stays mostly on track, this bull market has not yet reached its peak.
This article is just one example of the dozens of ways the seemingly random moves of the stock market can be understood with common sense. I don’t have a degree in finance; I have a degree in neuroscience. You don’t have to predict what stocks will do if you can predict what traders will do and be one step ahead of them. I made a 400% return in the stock market in five years using only basic principles of psychology and common sense. To read about how I did it, check out my book, Beating Wall Street with Common Sense, and stay tuned to www.tradingcommonsense.com!