Max Pacella
Investment Analyst
Macro & Markets
18 Mar, 2021

Like a high school essay, let’s outline a thesis statement at the very beginning of this note:

Anybody with the conviction, the capital and the aptitude should be able to access and participate in financial markets. Furthermore, investors should always take their own psychology and emotions into consideration as part of their risk management.

Calling an entire group of people ‘bearish’ or ‘bullish’ of course assumes that all aspects of the market move in unison, which as we have seen repeatedly, does not always happen – but the very polarization of this commentary reflects the psychology of the market at the moment, herds of bulls and bears defending their personal positions in an often unilateral approach.

The fact is that despite markets showing ‘bubble-like’ signs, the only thing we can do now is look at what is happening around us and make commentary on now, not what may come tomorrow.

That being said, let’s take stock of current market sentiment and thinking, touching on some of the more interesting points and concepts in what we can see today.

Economic Environment & Stimulus

Despite sluggish economic recovery and (in general) depressed underlying factors such as employment and wage growth, capital markets have been operating in a ‘land of milk and honey’ where money is cheap and accessible. This is what market observers described last year as the “k-shaped recovery”; Main Street collapsed, Wall Street rallied.

I’d like to borrow a line from one of my favourite financial newsletters, ‘The Daily Dirtnap’ – published by the talented writer and former Lehman’s trader, Jared Dillian.

“We don’t have straight-line economic growth, with semi frequent recessions.
What we have is a perpetual boom, punctuated by the occasional crisis

Jared Dillian

The current market thinking that you can’t lose being long, “Don’t fight the Fed”, is very much a result of central banks providing an ever-present ‘safety net’ to investors – particularly equities. The thinking goes that if the market slips, the Fed has the express capability to come in and flood the economy with cheap money – market sentiment doesn’t often need to look beyond surface-level opinion.

Staying with the example of the U.S. for a moment because the S&P and NASDAQ are two large components of global equity sentiment, one prevailing attitude is that increasing trade with assist in making the individual citizen better off. In the short-term, this may be correct, and in the long-term (as Keynes says) we’re all dead, so who cares?

But what market sentiment sometimes ignores – be it willingly or unwittingly – is that as the trade deficit rises (last year the deficit rose 17.7% to USD $679 billion), America is quite literally selling more of its assets to foreign investors, through increasing foreign liabilities. To fund this easy money, Americans are increasingly giving away their future capital– it’s analogous to the idea that to fund a lavish life now, you will give away 30c of every $1 you make for the rest of your life.

If you want to know more about the waning powerbase of the USD, Mike Young wrote a great note on it here.

Mr Market

One of the founders of what is now termed “value investing”, Benjamin Graham likened the market to an enthusiastic but emotionally unstable business partner named ‘Mr Market’. Since his mood will determine how close or far his prices are from the true value of a security, this partner presents constant opportunities for investment gains and losses.

Every day, Mr Market will knock on your door and offer to buy your holdings off of you – or offer you the chance to buy some of his. Since he represents the collective maelstrom of human emotion and irrationality that is the collective market, he flitters back and forth between totally euphoric and desperately panicked in his offers.

We discuss this because Mr Market offers us insight into the collective psychology of participants in equities, cryptocurrencies, bonds, commodities etc.

With soaring valuations and consecutive record-breaking highs, we can quite clearly see that our business partner is euphoric – he’s willing to come to us every morning at market open and offer increasingly higher prices for our holdings, whilst being so confident in the future of his own portfolio that his asking price increases all the time.

Looking at this chart of the Citi ‘Panic/Euphoria’ Index, we can see the level of excitement that the market is currently operating on:

Source: Citi Research

Even with a pullback, we are still in levels of euphoria above what we saw at the height of the ‘Dot-Com’ bubble. Our partner Mr Market is certainly enthusiastic at the moment.

Retail Participation and FOMO

There is absolutely nothing wrong with retail traders participating in capital markets; we operate in an open and free economy where if you are willing to take the risk to your capital, you deserve the reward of your conviction.

I started my involvement in capital markets by learning to trade foreign exchange CFDs when I was 17, an expensive mistake but a valuable one to learn early; it doesn’t take long for the addictive nature of watching your P&L update every moment to take hold, and to someone who hasn’t been involved in markets, trying to find sense of chart patterns can be a great source of entertainment..

But the level of retail participation seen today has historically been a sign of ‘nearing the top’; contrary to the signs plastering buses in Sydney, conventional wisdom says, “When you see Bitcoin in an ad, it is not time to buy”.

Coupled with the aforementioned central bank stimulus, retail participation has led to somewhat of a self-fulfilling prophecy. Faced with a bull market in equities and cryptocurrency, more money is thrown in to go long on the system – the market rallies higher, the next stimulus round comes and a new injection comes to add to the running of the bulls.

Someone said to me the other day – a person who has been trading cryptocurrencies and ‘meme stocks’ for around two months mind you – that they “don’t know how you could ever lose on a stock position, it’s so easy”.

This mentality is not relegated to this one individual; if this is your first time in the market and your crypto trading wallet is always showing green, or you’ve made a few quick gains by being long US stocks for the last twelve months, then it is rational based on your experience that we are growing to infinity and any pullback is just an opportunity to buy the dip.

The concept that best describes this is “Fear of Missing Out”, or FOMO.

When money is being made, every moment not invested into the market can represent ‘profits lost’ to an unexperienced trader. Peter Lynch covered this back in 1997 as one of the most dangerous things anybody can say about buying stocks:

“People say all the time, ‘Look at all the money I lost, because I didn’t buy!’”

We are seeing this with the short term rallies of stocks which Cathie Wood includes in her Ark ETFs, or the participation in short squeezes induced by Reddit – whilst it’s plain to see there are many smart people identifying opportunities, the majority of this trading volume is driven by an overwhelming desire to jump into the bull run regardless of the original investment logic or the risk.

To put this another way, ‘traders’ (not to be confused with ‘investors’) may allocate a ‘stop-loss’ position to one trade or another, but it seems that right now most do not have a stop-loss in mind for their overall portfolio. The prevailing psychology is to be involved and be long at all costs, even if it means riding the position down for the sake of conviction.

Stimulus and Inflation Expectations

We’ve touched on inflation expectations in equities and fixed income here, here and here, so let’s not cover old ground. But what is important to cover briefly is the impact that market concerns have had in the increasing appeal of cryptocurrencies.

MicroStrategy CEO, Michael Saylor, offers an insight into the broad market psychology on this topic, as he is followed by many individual traders as a source of truth on Bitcoin in particular.

In Saylor’s view, monetary supply (specifically “M2 Money Supply”, a topic you can read more about here) is increasing at rates which traditional capital markets can’t keep up with – the figure he specifically references of late is 24% p.a. In his assessment, this is affecting the ‘cost of capital’ involved in equity markets but is not reflected in non-scarce goods or non-assets, so inflation will not increase proportionally.

What does all this mean? If you subscribe to his assessment, which many do, then you have to be in an asset class that’s growing at least 24% to retain buying power. Coincidentally, Bitcoin is doing just that. It is not difficult to see how this particular area of market psychology would encourage increasing participation of individual investors in cryptocurrency.

The true merit of his assumptions, that can be discussed in a later note.

Search Your Feelings

The market is seldom perfectly clear, much as human emotion is equally murky at times.

Even in this sample of current prevailing ideas/thoughts, we can make the overarching statement that “everybody is bullish something”. If you’re predicting a bubble in equities, you may be long cryptocurrency, and vice versa.

Given the economic backdrop and market momentum, this may not necessarily be an incorrect position to take. Understanding the market and how to invest often comes down to understanding how those making up the market think; the ‘popular’ or ‘consensus’ trade goes in and out of favour like any market cycle.

As investors we have to check our way of thinking, how it is influenced by factors around us, and include this as a part of our risk management.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.