In just over a year, the Dow has recovered to 11,204, from 6,547. The biggest rally of our lifetimes has lifted markets over 70%. Paradoxically, now's time to be more cautious, while a year ago was the time for optimism. Why was optimism warranted when the world was falling apart? Why is caution more appropriate now? The answer lies in the nature of markets.
To go against the grain of anything is, well, counterintuitive.
Our lives glide most easily on the broad wings of intuition. The most human elements of our lives--love, family, and friendship--are intuitive and instinctive. There's not much purpose in contradicting the natural. We are, after all, not as distant as we would like from our Neanderthal ancestors: 45,000 years is a blink of evolution's eye. For a cave dweller to ignore instinct was fatal.
But the financial markets reverse this natural order of things. In an ecosystem where prices reflect instinctive thought, no one can outsmart the system by reacting to such thought. Put another way, the markets price in all consensus emotion by the tick. If you are panicked, others are too, and their mood has already set the current price level. If you are euphoric about world events, so are your neighbors. Prices already reflect their optimism. The stock market is like an auction by millisecond: bids are instantaneous and prices immediately reflect human emotion. Prices do not wait for emotion; they are literally defined by it. The sheer number of participants and trades ensures relatively efficient pricing, where the market sops up human greed and fear as soon as it exists.
Behavioral finance tells us that markets are psychological thermometers, taking our mass temperature and distilling the result into one number, say Dow 6,500 or Dow 11,000.
The market looks at fundamentals, such as earnings, cash flows and interest rates and then applies an average price to them. But whether that price is high or low depends on our collective mood.
Since markets price in current emotion, it follows that the only way to beat the market is to go against it--that is, buy when others are selling and sell when others are buying. As Warren Buffett says, "Be greedy when others are fearful and fearful when others are greedy."
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