"There may be a recession in terms of stock prices, but not anything in the nature of a crash" – Irving Fisher, leading US Economist, September 1929
"Stock prices have reached what seems like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from current levels, such as predicted. I expect to see the stock market a good deal higher within a few months" – Irving Fisher, October 1929
"The end of the decline of the stock market will probably not be long, only a few more days at most" – Irving Fisher, November 1929
The very unfortunate timing of these quotes from Irving Fisher serve to highlight how optimistic human nature can be! Not only were predictions of higher stock prices made on the eve of the 1929 depression, but when the predictions proved erroneous the downtrend was also believed to be only short-lived.
Are you an optimist or a realist? Jump on board some weighing scales and find out!
The optimist jumps on the weighing scales and sees a number higher than expected. What does he/she do? Jumps off of course! After all, the number disagreed with the expectation. Then the optimist jumps on board again to see if the number changed second time round. Moreover, if the number was better than expected first time around, the optimist jumps off the scales, delighted with the result. The realist, in contrast, simply accepts the information presented either way. The realist sees no need to jump on board the scales a second time because he/she trusts the data presented.
In the stock market, the natural tendency to be optimistic aligns with a self-serving bias. In order to move from optimism to realism, we must recognize that we have a natural proclivity to question information that disagrees with us and to accept data that aligns with our beliefs.
In the stock market, the same biases accompany trading decisions. For example, recent figures showed money market cash skyrocketed to $3.45 Trillion – 56% higher than the March 2003 low! So, with so much money moving to cash, what happened to the Investors Intelligence Sentiment Index for stocks in March?
It dropped, of course! Just as optimism is pervasive when market participants are bullish, so too is pessimism pervasive when positions have been sold and cash becomes a sanctuary. After all, market participants who sell MUST believe the stock market is going to decline further and so their expectation is bearish. Indeed, the readings on the Investors Intelligence survey were as low in March as they were in October 2002. This is startling given the fact that many of the major indexes had dropped by almost 20% in March, whereas in October 2002, the NASDAQ dropped by approximately 70% from its highs!
Recognizing that the objectivity of our judgments may be clouded by our biases, it is imperative that we always hedge virtual portfolios. Whether the market is moving up or down is irrelevant, bullish and bearish positions should be in place. However, the weighting of bullish and bearish positions is what counts.
When wildly bullish, smart virtual portfolio management would dictate that even an aggressive trader would put no more than 75% of positions into bullish trades, while the remaining 25% would comprise hedging in the form of short calls and long puts.
Some hedging is always warranted. Phil pointed out in his weekly wrap-up the detrimental impact of having short calls on some Google positions going into earnings. But the bottom line is his day trading virtual portfolio is up 49% in a week in spite of those hedges!
Even if a virtual portfolio was fully balanced, 50% bullish and 50% bearish, the magnitude of this week’s moves in the market would mean that the bullish positions would keep on winning while bearish long puts could only lose a certain fixed amount of capital – the amount spent purchasing them.
And as the market rises substantially like it has done this week, smart virtual portfolio management dictates that some profits should be banked and some additional hedging is warranted.
As a final note, this week brings a mountain of earnings data again. We’ve already seen Google’s stock price respond to earnings with a near $100 gain while Intuitive Surgical’s stock price declined $60 post-earnings. So, make sure to remember if you are holding positions going into earnings, volatility post-earnings could be HUGE and trade accordingly! Also, if you are considering more or less hedging, remember how our natual biases affect our perceptions and think twice before abandoning the protection that hedging affords!
