The Psychology of Fear - weekly recap

These days there is no other subject in people’s mind but the economy. For the past weeks, I’ve been taking calls from friends who, concerned about the economic situation, decided to “do something about it”. A friend is buying few extra guns, extra canisters with gasoline, canned food, water, tent, and other supplies in case “there will be a civil war”. Not a joke, I swear. Others are looking for comfort, for reassurance that this too shall pass and we’re returning to a normal life. Now, notice, these are people who don’t know who or what Dow Jones is, nor their personal lives have been impacted in any way by this crisis in a sensible way. They still have their jobs. True, they see their 401(k) shrinking faster than you say “bailout” but still … the gallon of gas is still $3.752 (average, in Chicago), the gallon of milk is about $3.52 … the unemployment rate is 6.15; it will likely increase in the coming months close to 7%, but is still a far cry from 25% of the Great Depression.

Should we be so concerned?
To me this is a reverse of the 2004 – 2005 euphoria, when everybody and their grandmother were rushing to buy a condominium in Florida, Nevada or California, only to flip it over the next day for a quick profit. There were waiting lists for the ‘unlucky’ ones who did not get in on the first try. I now see the same thing, only in reverse. When everybody is so panicked about the economy that it makes for a good conversation anywhere, and at any time, it may not be too bad of a time to think about getting back in. No, I am not calling a bottom; I don’t know when is going to happen. But it seems that we’re getting ahead of ourselves by succumbing to panic.

Let’s look at some facts.
The stocks are down 40% for the past 12 months and far surpass the average bear-market slide of 30% since 1940. They seem to be running ahead of any recession, by pricing in pretty horrible times ahead. The Dow is down almost as the 45% downslide in the 1973-1975 recession, and its 12-month decline far exceeds the 24% it lost in the period leading up to and during the 1981-1982 recession.
The prices look much more reasonable today. The S&P 500 trades at 11.6 times the profits that analysts expect them to earn next year. The index trades at 17.1 times the companies’ most recent earnings. That’s only slightly below the market’s 60-year average P/E multiple of 17.8. Granted, the current P/E is still high compared to the low P/Es of previous major recessions. During the ’74, ’80 and ’82 recessions, the S&P’s trailing P/E dropped to between 6.8 and 7.2.
These are not reasons to get out of the stock market. Think about the following: $1 invested in stocks from February 1966 through May 2007 would have grown to $16.58 in that period, which calculates to a 7% annual return. By contrast, investors who were out of the market in the five best days (five!) each year during that span were left with only 11 cents. Stay invested, my friends!

The “deer in the headlights” feeling
How do we explain the irrational price of Anheuser-Busch (BUD) shares? BUD is set to be acquired by InBev (INB) for $70 a share in cash, with a closing this quarter that looks on track. The stock closed Friday at $58.50. What gives? Maybe the expectation that the deal will not close in these economic conditions. Possibly, but unlikely. So this irrationality, or as behavioralists would say, an ‘anomaly’, would give you a 20% upside to the bid price, or an 80% annualized return.
The market is moving now on fear, not facts. That is the only resemblance with the Great Depression. The government’s actions are tough, swift and the markets will soon move in the right direction. Regardless of how much further it might (or might not) drop, the stock market now abounds with so many bargains it’s hard not to step on them. Out of 9,194 stocks tracked by Standard & Poor’s Compustat research service, 3,518 are now trading at less than eight times their earnings over the past year – or at levels less than half the long-term average valuation of the stock market as a whole. Nearly one in 10, or 876 stocks trade below the value of their per-share holdings of cash – an even greater proportion than Ben Graham found in 1932.
For example, Charles Schwab Corp (Ticker: SCHW) holds $27.8 billion in cash and has a stock market value of $23.26 billion. Nam Tai Electronics (Ticker: NTE), a Chinese contract maker of consumer electronics and other goods, has $271.85 million in cash and a market value of $266.23 million. GSI Group (Ticker: GSIG), a supplier of precision motion component products, has a market cap of $102.13 million and a cash position of $183.27 million. And these are companies which have more cash than market cap. But there are plenty with solid cash position as a percentage of market cap. To name a few here: Microsoft (MSFT) 11.6% cash as % of market value, Apple (AAPL) 26.4%, Motorola (MOT) 29.9%, Electronic Arts (ERTS) 30.2%, Loews (L) 30.2%, RealNetworks (RNWK) 81%, InterActive Corp (IACI) 65%, etc.

Back to psychology. Many of us, it seems, are in the grip of what psychologists call “the disposition effect”, or an inability to confront financial losses. (By the way, in behavioral finance, this effect also describes the tendency of investors to ride losers, and sell winners.) The natural way to moderate the pain of losing money is by refusing to recognize exactly how badly your portfolio has been damaged. A few weeks ago, investors were gasping; now, they seem to have gone numb, judging by the unexpectedly low number of calls to financial advisors and investment consultants. Stupor may have set in, and if that’s the case, the next stage will be ‘capitulation’, when the investors ‘let go’ and sell in panic. That will be the signal that the markets are ready to rise again. However timing the bottom is dangerous. It may be better to get in somewhere near the bottom, than wait for it and miss it.

Good luck!

Sources: The above data draws from Barron’s, Wall Street Journal and Investor’s Business Daily and also from several sources cited by these newspapers.