By Andy Gold
On November 28, 1940, at the age of 63, Jesse Livermore had reached his breaking point. After years of suffering from depression and a career of making and losing fortunes, Livermore committed suicide. Years ago, I served as a technical market strategist for several Wall Street firms. Early in my career, my mentor suggested that I read Livermore’s book entitled “Reminiscences of a Stock Operator”. While journalist Edwin Lefevre is given credit as the author, it is widely speculated that Livermore himself penned the classic book. Livermore’s infamous trading sense led him to short sell the stock market prior to the 1929 crash, during which he amassed an estimated $100 million dollar fortune, only to lose it all shortly thereafter.
His life, and the experiences detailed in the book, underscores the effect of irrationality that circles the financial markets each day. Even with his vast awareness and recognition that emotions drive irrational decision-making, Livermore himself succumbed numerous times to these forces, and ultimately the impact of these decisions contributed to his death.
I learned a lot from this book, but the most important lesson I took was discovering the concept of loss-aversion. Livermore wrote, “Losing money is the least of my troubles. A loss never troubles me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does the damage to the pocket book and to the soul”. Adam Smith, who many consider to be the father of classical economics once wrote that “we suffer more when we fall from a better to a worse situation, than we ever enjoy when we rise from a worse to a better.
This insight has led to volumes of research among behavioral economists and psychologists in the area of loss aversion, the concept that individuals will go to great lengths to avoid incurring a loss. Loss aversion is a powerful force and drives many poor decisions that we make. This principle is most blatant in the realm of trading stocks, bonds, derivatives and other financial instruments. Rather than taking a loss when it first occurs (due to an aversion to loss), many investors will instead rationalize why it is ok to keep the investment position and may actually commit more money to it.
These emotional dynamics make technical analysis and behavioral finance so important. Technical analysis provides three core insights for investors. First, it provides a quantifiable manner in which to measure the emotions of the market. Second, is the general belief that a price chart of a financial asset or market (stock, bond, currency) reflects future expectations of how that asset or market will perform, and therefore a chart has predictive value. Third, technical analysis does not believe in a rational market and instead assumes that individuals behave irrationally. This approach contrasts sharply with a fundamental value investing strategy (see Graham and Dodd security analysis). This stratagem is largely predicated upon a detailed analysis of firm’s finances. According to Graham and Dodd, a well-disciplined investor can determine a rough value for a company from all of its financial statements, make purchases when the market inevitably underprices some of them, earn a satisfactory return, and never be in real danger of permanent loss.
Technical market analysis was the predecessor to what is referred to today as behavioral finance (See Dr. Harvey Krow’s book entitled Stock Market Behavior: The Technical Approach to Understanding Wall Street). Both disciplines assume that individuals, more often than not behave in a behavioral state of irrationality. This dynamic occurs when one is both making and losing money. The investor making money is ultimately faced with the emotion of greed, and irrationally believes that the asset will never decrease in value. The investor losing money can be engulfed with fear and gradually becomes suffocated with loss aversion and as a result of not wanting to take a loss, ends up ultimately taking a greater loss.
One byproduct of irrational investor behavior is the formation of asset bubbles which occur from time to time, building at an accelerated pace, and all along creating a sense of invincibility. Think of gold prices today, real estate in 2006, dot.com stocks in 1999, and so on. All of these periods have several things in common. A widespread belief, almost arrogance that these investments are invincible, will continue to make money forever, and there is a void of any rational explanation to suggest otherwise. Very few ever see the reasons why bubbles are about to burst, until they burst. Then everyone can easily explain to you all the reasons why the bubble collapsed.
The old Wall Street adage to never confuse brains with a bull market is so true. Investors like to think of themselves as increasingly intelligent about their stock selections, particularly when the market is pulling everything up with it. You begin to convince yourself that you have things figured out, and as a result you take comfort in this notion and become complacent. Asset prices tend to move in unison with the overall market trend. For example, you may own a great quality stock, but if the market implodes, so will your stock.
In Burton Malkiel’s book A Random Walk Down Wall Street, the Princeton Professor theorized that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” As it turns out, the Wall Street Journal has conducted a dartboard contest for years measuring the performance of “experts” vs. people who randomly threw a dart at a dartboard holding a printout of stocks. The results have established a slight edge to the experts. However, over forty percent of the time, the dartboard portfolio has outperformed the experts.
Both technical analysis and behavioral finance provide individuals with an ability to identify patterns of human behavior that uncover opportunities for profits. Sentiment can be measured in many ways, and for the purposes of this article should be used as a contrary indicator. That is to say that when everyone is bullish, it is a good time to become defensive and when everyone is negative, one should consider buying the market. The tools we can use to gauge these sentiment swings, when used properly can mitigate the impact of our reliance on hoping that things will get better and thus avoid falling prey to loss aversion. This counter-intuitive strategy does not make sense to many, but its record of accomplishment as a predictive tool is strong. One quantitative measure is the level of put and call option buying activity. Call options are derivative products that allow someone to speculate that the underlying asset will rise in value. A put option provides a person with a chance to make money on the asset losing value. In general, a high put/call ratio implies a strong degree of fear has taken hold and these readings tend to occur at or near a market bottom and prior to an advance. A low put/call ratio implies a disproportionate level of call buying activity, which tends to occur after significant moves higher in the market. Why is this so? The only way the put call ratio will decline, would be because there is greater call buying (a bet that the asset will rise in value) activity. Why would an investor desire to bet that asset prices would rise? A stronger stock market will sway individuals to begin to shift their mindset away from fear of falling asset prices toward fear of missing the next move up.
The key of course, is to buy when no one else wants to, and this occurs when investor sentiment has reached an extreme. When the put/call ratio is extremely high (over 85%), you will feel like the hardest thing to do is to commit money to the market. This should be confirmation that doing exactly that is the right thing to do. Markets never look good before they are about to rise and always look invincible prior to collapse
All of these points, brings me to the conclusion of may article. Talk to your friends, or conduct a survey about what direction people think the value of gold is headed and you will get a consistent response. Most people will tell you that gold is going up. Not only will people be able to tell you which direction gold is headed in, but they will be able to provide you with an ample amount of explanation for why they believe this to be the case. People will ignore the fact that in 2002, gold was approximately $300 per ounce. Five years later in 2007, gold had doubled in value reaching $600 per ounce. Since then, Gold has tripled in value to stand at $1,800 per ounce. This type of accelerated move in a market does not occur often and all of the pieces are falling into place for a sharp decline in gold prices as a result.
People will tell you that such an accelerated rise is justified for various reasons, all of which sound highly rational and easy to understand. Some will also explain monetary policy to you and illustrate how the United States has been forced, and will continue to be forced to borrow large sums of money, and additionally will print money, which devalues the dollar and makes gold worth that much more. Some will even explain how the prospects for QE3 (quantitative easing) will further devalue the dollar and in turn yield even higher commodity prices (inflation), gold in particular.
What the consensus will struggle with is giving you any rational explanation that would lead to a conclusion that gold prices will collapse. Sentiment toward gold is extremely positive and therefore, we have in my opinion the three critical ingredients of a market bubble in gold. First, very few seem concerned with the accelerated rise in price that has occurred and will view any pullback in gold prices as a buying opportunity. Second, is a consensus view that gold has nowhere to go but higher. Third, any person who thinks that gold prices are going to decline (not many these days) will be ridiculed, thought of as being misinformed and frankly considered by most to be not very intelligent.
So what can we learn from recent history and asset bubbles? During the period of 2005-2007, real estate was considered to be invulnerable and a “no brainer” investment. Television was barraged with TV shows about how to make money in real estate. People quit good paying jobs to flip houses. Buyers of real estate were forced to compete with other buyers in the marketplace and bid against one another driving home prices above the original asking price. Anyone who did not have a real estate investment was considered naïve and was missing the greatest opportunity to make money in a long while. Speculators were buying and selling condominiums for a profit before they had even been built.
Today with gold, we are seeing many of the same behavioral characteristics that we saw unfold in the real estate market. In fact, these similarities are so blatant and in our field of vision, yet just like with the real estate bubble, we are choosing to ignore these warnings. TV commercials and infomercials abound about making money in gold. Speculators have become increasingly leveraged to gold. No rational explanation appears obvious that could explain a sudden drop in gold prices. There is a feeling of invincibility in owning gold, as was the case only a few years ago in real estate. Are our memories so short that we forget about the lessons of history, or do our irrational emotions get the better of us and convince us that this time is different?
Does this mean that gold is going lower? In my view, the easy money has been made in gold and the next big opportunity to make money in gold will be on the way down, not up from here. Greed is firmly taking hold in the gold market, and this emotion will unfortunately lead many to lose money. As Jessie Livermore once said when describing the financial markets, “The game does not change and neither does human nature”.