The Psychology of a Sell-Off

Investors’ “irrational exuberance” leads to overvaluation—the resulting market correction leads to opportunity.

2016 is off to a rough start.

Just three weeks into the year, US stocks have already fallen by more than 10%. The Dow dropped 249 points on Wednesday alone, and other indices across the world have crashed. Oil prices have plunged to less than $30 a barrel.

In other words, it’s a great time to think about buying, says Hersh Shefrin, finance professor at the Santa Clara University’s Leavey School of Business.

Shefrin is the author of numerous books and research papers in the area of behavioral finance. His latest book, Behavioral Risk Management, focuses on the psychological pitfalls at the root of disasters such as the 2008 financial crisis.

According to Shefrin, financial instability such as the ongoing sell-off is the result of what many behavioral economists refer to as “irrational exuberance”—investor enthusiasm that drives asset prices up to an unsustainable level.

More specifically, it occurs when price/earnings (PE) ratios are climbing, typically as a result of low interest rates.

“When you start from a level that’s too high and you have a change in fundamentals, it makes the drop precipitous.”Nobel Prize-winning economist Robert Shiller described the phenomenon in his 2000 book, Irrational Exuberance: “News of price increases spurs investor enthusiasm, which spread by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”

The end result is a bubble—and one that will eventually pop, said Shefrin.

“When PE hits 25 or above, that should make investors concerned—not necessarily that markets are going to crash tomorrow, but that we’re in a situation that’s not sustainable,” Shefrin said. “The earnings potential underlying the equity isn’t there to support those kinds of returns.”

When investors lose their confidence in the economy—because of a slowdown in China, for example—the resulting decline in the market is that much worse because it had been overvalued.

“When you start from a level that’s too high and you have a change in fundamentals, it makes the drop precipitous,” said Shefrin.

US, UK, China stock and oil - 3 monthsUS, UK, China, and oil over three months ($ terms). Source: FE

As Oaktree Capital Management Co-Chairman Howard Marks wrote in a recent client memo, dramatic market fluctuations occur because investors “tend to emphasize just the positives or the negatives much more often than they take a balanced, objective approach.”

“First they exhibit high levels of optimism, greed, risk tolerance, and credulousness, and their resulting behavior causes asset prices to rise, potential returns to fall, and risk to increase,” Marks wrote. “But then, for some reason—perhaps the arrival of a tipping point—they switch to pessimism, fear, risk aversion, and skepticism, and this causes asset prices to fall, prospective returns to rise, and risk to decrease.”

These pendulum swings should be taken as signals—for it’s times of pessimism, fear, and skepticism that create “vastly improved buying opportunities,” Marks wrote.

“If I could know only one thing about an investment I’m contemplating, it might be how much optimism is embodied in the price,” he continued. “I want to buy when I can benefit from the herd’s neuroses, not when they’ll penalize me just as they do everyone.”

Shefrin likewise suggested a contrarian strategy of buying equities when markets plunge and selling when markets rise.

“The best thing to do is to hold a well-balanced portfolio and to rebalance it fairly frequently as we go through market turmoil,” he said.

But while he said the ongoing sell-off should be taken as a sign to begin buying again, Shefrin noted that market timing is an imprecise science, particularly when the unpredictability of investor sentiment is taken into account.

“Markets may plunge even more, so you could end up buying something that goes way, way down,” he said. “It only works in the long-term, it doesn’t work in the short-term.”

As Marks put it, while it may be “a time” to buy, it is not necessarily “the time.”

Related: Beyond Rational: Investor Sentiment and Risk Perceptions