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Investor psychology during the sell-off

A reader asks:

The S&P returned 18% in 2020 after a chaotic year, reduced volatility in 2021 and the S&P returned 28% – its on investors considering how much has gone over the years and how US markets continue to perform What is the psychological effect? , With that in mind, is the recent selloff purely valuation based or do you think there is dynamics in practice as well?

There are several reasons why the stock market is selling out (see here for my list).

Clearly, this week has been going to go to war with Russia’s Ukraine.

But historically there have been times when the stock market ignores geopolitical events, the Fed or economic data.

Then there are times when the markets are very concerned about these factors.

What’s the biggest difference? Why does the market sometimes care about this stuff but sometimes ignore it?

If I had to narrow it down to one reason it’s probably the price.

After huge gains, some investors are definitely going to find reasons to sell and lock in their profits. And after big losses, some investors are always going to find reasons to buy, even when the news is looking grim.

During a bull market, everyone looks like a genius and it seems like the good times will last forever. Things do get better but eventually they get better at a slower pace.

Once the high expectations are built into the underlying and the performance is good, it becomes much easier for investors to sell. Many investors want to lock in their profits when things start falling apart.

Sometimes these corrections turn into bear markets.

During bear markets everyone looks like an idiot and it seems like the bad times will last forever. Things get worse but eventually they get worse at a slow pace.

This is how markets turn downwards and upwards.

rinse and repeat.

These cycles don’t work on schedule but you get the idea.

Let’s look at the past three years’ gains for the S&P 500:

  • 2019 +31.5%
  • 2020 +18.4%
  • 2021 +28.7%

Nasdaq 100 now:

  • 2019 +39.0%
  • 2020 +48.6%
  • 2021 +27.4%

That’s a three-year total return for the S&P 500 and over 160% for the Nasdaq 100.

The returns have been phenomenal.

Growth stocks, especially the technical kind, have been getting crushed in recent months, with many names down 50-80% in the past year.

Why is this the case?

Sure, there’s the Fed and rising rates and high inflation and heightened expectations from the pandemic. But this group also experienced outstanding returns for many years.

The Nasdaq 100 overall was up more than 1400% from 2009 to 2021. That’s an annualized return of over 23% for almost a decade and a half. Good times can’t last forever.

The Black Monday crash of 1987 is a perfect example of this phenomenon.

There were a lot of structural forces that helped cause the worst one-day accident in history.

Interest rates were rising (at about 10% for a 10-year Treasury bond) and portfolio insurance helped set off a cascade of sell orders that day.

But even before that crash, stocks had experienced huge returns.

The S&P 500 was up about 40% (and without dividends) before the crash during August of that year:

And that 40% return was followed by 20% annual returns from 1982-1986.

Sometimes the reason stocks drop is because the gains were too great for too long and investors’ expectations fall out of reality.

You can attribute this to higher valuations, but in the short term, it is investor psychology that matters.

I think it could turn into a complete crash when you consider all the moving pieces involved in the global economy.

But it is also important to remember that most of the time the stock market falls, the chances of a correction are far greater than a crash.

By my calculations, that’s a 37th improvement of 10% or worse1 From 1950 to the S&P 500. The distribution of those improvements looks like this:

Roughly 3 out of every 4 double-digit drawdowns is just an improvement (by my definitions here). Bear markets, crashes and full blown crises do happen but they are rare.

Of course, that doesn’t mean that this improvement won’t turn into a crash. This is where investor psychology makes it extremely difficult to predict this stuff.

Just as the stock market can overshoot upwards, sometimes the losses turn into losses and the pendulum swings too far in the other direction.

The world seems to be falling apart at the moment.

Someday it won’t feel like this anymore.

I don’t know when

We talked about this question on this week’s Portfolio Hedge:

bill sweet Join me to discuss questions about crypto’s tax treatment, the tax retirement withdrawal strategy, and the weirdest tax write-off people can try.

Further reading:
3 ways to win during a market correction

1At the time of writing, the S&P 500 is down about 13% from all-time highs.

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