Mr. Market's Mood Swings

Interestingly enough, the recent sharp stock market correction has highlighted a much discussed, but often rarely experienced phenomenon in investing literature: that of the mood swings of Mr. Market. As you all may know, Benjamin Graham, the father of value investing, created this very apt and interesting allegory to describe the volatile nature of the stock market daily fluctuations. He used an imaginary character called Mr. Market and likened him to a real-life person who would always be available to offer you a quote (price) to either buy or sell a particular company. Like all of us, Mr. Market had mood swings akin to any normal human being: sometimes he would be irrationally exuberant and offer a very high price for the business; while at other times (such as the last 3 days) he would be manic-depressive and see nothing but bad days ahead and offer a very low (ridiculously) price for the same company. We as investors are free to either accept his price or ignore it.

So how does this tie in to the topic ? Well, Mr. Market's mood swings tend to be more towards the extreme when he becomes manic-depressive, as can be witnessed in the last 3 trading days. In the last 5 months before Ju,ly 2007, all was sunny and bright and Mr. Market remained cheerful and optimistic. Suddenly, within a space of 3 short weeks, his mood swung to the other extreme and he was offering bargain basement prices for fundamentally strong companies. Isn't it amazing how volatile the mood swings of Mr. Market can be ? It is OK for us to ignore him as he will always be back the next day with a new quote. The danger is when his mood influences YOURS as well, and you give in to the same state as Mr.Market and fail to objectively appraise the value of the business. I took advantage of Mr. Market on Friday and accepted his offer of S$0.615 per share for Pacific Andes.

In analyzing his mood swings, several factors should be taken into consideration to explain why his manic-depressiveness comes so rapidly, swiftly and suddenly:-

a) Loss aversion - Mr. Market, like all of us, has a mental loss aversion system which tells him that the pain of a loss is more than twice the enjoyment of a gain. Thus, he feels the pain of a loss more acutely and desperately tries to offer ANY price just to get rid of his stake in a company, fearing that the sky would fall on him.

b) Programmed Selling - Many hedge funds, institutions and mutual funds have automated programs which trigger sell orders if the price of a security falls to a certain level. This is to "protect their profits" and ensure that they do not suffer a massive price drop from which they are unable to recover from.

c) Short-sellers - Short-sellers are people who sell shares of companies they do not own (by borrowing scrip). In SGX and USA, this is allowed but the person must "cover" (buy-back) within the same trading day. In market corrections, short-sellers come out in force to depress prices further as they hope to buy back at a much lower price. Since prices fall a lot faster (in general) compared to rises, this has the effect of severely depressing a company's stock price, sometimes to ridiculous levels.

d) Margin Calls (Forced-Selling) - Trading on margin is a common term used to describe people who invest/trade in the stock market using leverage. Commonly, they are allowed to borrow up to 3-4x the value of their shares, using their shares as collateral. Once prices fall below the margin limit (for more info on this, I suggest asking your broker !), they have to "top up" the margin account with cash. Those who are unable to do so will suffer forced selling of their shares in order to satisfy the collateral.

The 4 factors above are very pervasive in a market which is crashing, and contributes greatly to the manic-depressive mood of Mr. Market. Also take note that bad news usually comes in waves and does not seem to stop once panic selling begins. This is just a perception, actually, as people's minds are already attuned to bad events and thus selective filtering ensures that the bad news sounds worse and the good news sounds muted. In all probability, such "bad news" was already circulating during bull markets but the media, press and so-called "pundits" helpt o exacerbate the situation by headlining every single piece of bad news and putting it on the front page in BIG, BOLD letters (I was surprised they didn't use red font).

Some examples can be seen in the recent front pages of newspapers, where the words "market rout", "sharp sell-off" and "possible economic recession" are repeated again and again. One must remember that the sub-prime issue was already present 9 months ago; so why do people start making noise only now ? All because bear Stearns and BNP Paribas said that some of their funds could not be valued ? Sounds like a massive over-reaction ? You, as the intelligent investor, should be the one to decide.

Note: Next post will be on Global Voice's 1H 2007 review (probably Monday evening).

P.S. - Please feel free to leave comments on ANY posting of mine. I will be informed through email and will reply personally to every comment (as long as it's not frivolous haha !).