Why do birds suddenly appear, every time there is fear ?

Those who are into music (oldies to be exact) may recognize the title as a spoof of a song sung by The Carpenters called “Close To You”. As I was humming this tune innocently, the twist in the lyrics just came to me and I could not help penning it down as a posting; just please forgive the corny change in the original lyric which still manages to somehow rhyme ! For those who are curious, the original lyric is “Why do birds suddenly appear, every time you are near”.

The title actually refers to my observation that stock markets in general tend to rebound sharply and suddenly after a prolonged period of fear, trepidation and uncertainty. After some thought and some additional reading from investment and market psychology books, I have come to realize that this effect is actually rooted in expectancy and anticipation. Both are contributory factors which determine the tenor of the market and whether there is irrational exuberance or misplaced fear. I shall touch on the former first, move on to the latter then attempt to gel the two together to make a coherent argument as to why the mixture of the two has such a dramatic impact on the stock market.

Expectancy refers to expectations of certain events and their likelihood of occurrence will determine the magnitude of the psychological reaction. A good example would be expectations of a 50% jump in profits for Company A, based on Company A’s track record of good growth and also prudent and steady Management. Expectations would be high for the Company to grow its profits by more than the long-term average of 10-20% due to external factors as well, such as a booming economy, favourable economic policies or strong interest in that industry. This is an example of expectations being pushed high as a result of a myriad of factors. The result is that if the Company reports a 30-35% increase in earnings, the result is a drastic sell-down in the Company’s shares as expectations were not met. This is also known as the “expectation gap”. The magnitude of a psychological reaction to an expectation gap depends on the strength of belief in the outcome, as well as the depth of difference between the perceived outcome and the actual result. The converse is also true for expectations of poor performance, but the reader should note that the resultant positive reaction is largely more muted than one composed of negative surprise. This is due to the previously mentioned over-reaction bias inherent in all humans, who tend to over-accentuate the negative and discount the positive.

For anticipation, this usually relates to market participants anticipating some positive news such as M&A deals, contract wins or other related corporate news which is unrelated to periodic results announcements (which are mandatory). Though one may argue that they are one and the same, anticipation from an unplanned event may actually have an even greater impact on market psychology than a positive expectation from an earnings surprise. This is in part due to the fact that earnings are a quarterly event and their timing can be reasonably ascertained; hence the only unknown is the magnitude of the drop or rise in earnings. Whereas in the case of corporate events or contract wins, though there is usually some anticipation built in, the news may still come as a complete surprise. This usually provokes a much bigger reaction as the unexpectedness of the news catches everyone by surprise and like lemmings, everyone rushes to jump on the bandwagon. The flip side of such anticipation is that without the associated newsflow to support such anticipation, the initial reaction will gradually fizzle out and cause a deflation in market sentiment and lead to a share price collapse. This is why I often state that one should purchase companies when expectations are low rather than high, because prices will be bidded down much more when expectations are low and there is greater margin of safety as long as you know and are confident that the underlying business remains sound. If one purchases based on high anticipation or high expectation, one can expect to be disappointed if things do not turn out as planned.

The mixture of expectation theory and anticipation of certain corporate events creates a heady and unpredictable mix of uncertainty which causes companies to be mis-priced. It is precisely these emotions which Mr. Market exhibits which result in companies trading at sometimes ridiculous valuations, and the job of the astute investor is to pounce on juicy opportunities when they present themselves, and to steadfastly ignore companies which have too much expectations priced in. A recent example is Midas Holdings, which has made a total of 4 contract win announcements over a period of 3 weeks. Impressive though this may seem, I suspect this news was largely priced in because analysts and investors had already been anticipating these events some time before their occurrence. Thus, the high valuations accorded to Midas by these analysts have already incorporated their bullish predictions; thus a margin of safety cannot be present with such inflated expectations. Don’t get me wrong though – I am in no way implying that the Company is a bad one, but there is always a price to pay for earnings and cash flows, and to me the risk-reward ratio does not seem favourable in the long run should one purchase at lofty valuations.

Benjamin Graham, widely recognized as the Father of value investing, says: “Today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus, what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss”.