Courtesy of Vitaliy Katsenelson
In the classic book The Wizard of Oz, the Wizard decreed that everyone who entered the Emerald City wear green-tinted glasses. Visitors and citizens were told that this was to protect them from the “brightness and glory.” In truth, though, the Wizard had lost his mojo and become a run-of-the-mill charlatan. There was no brightness and glory, just an ordinary city built out of stone and glass.
Bull markets are Emerald Cities of our own making. In a bull market it is decreed that investors and the media shall wear green-tinted glasses. Suddenly, all economic news and fundamental facts turn green and glittery — there is no bad news, only shades of good.
In a bear market the mandate is different: Everyone is to wear red-tinted glasses. The Emerald City is no more. Now all news comes in three shades of Soviet Kremlin red: bad, ugly and downright devastating.
This happens because we are human. The pressure of rising prices in bull markets or falling prices in bear markets leads us to engage in backward analysis. Instead of first analyzing the events and only then forming an opinion, we look at the market reaction to the news and let it dictate what we should think.
In the long run, stock prices follow fundamentals like cash flow and earnings growth. In the short run — well, this old cowboy saying tells it all: “Nobody but cattle know why they stampede, and they ain’t talking.”
The danger of wearing glasses determined by the market is that reality will not be suspended forever, no matter the tint of your shades. By following the “color decree,” you are effectively taking advice from the market on how to analyze, what to pay attention to and what to buy or sell. This is the sure road to buy-high-sell-low despair. The market is the worst giver of advice — it’s prone to tell you what you should have done, not what you should do.
Before the market mandated green glasses in October, investors were wearing blood-red shades. They were dreading significant risks threatening the global economy. Let’s quickly run through them and see if much has changed.
European recession and debt crisis: Greece went through an orderly default, the European Central Bank pumped liquidity into the system, and European bond yields declined. But a recession precipitated by governmental austerity is not off the table, and the PIIGS (Portugal, Ireland, Italy, Greece and Spain) still have to figure out how they will deal with their debt and lack of economic competitiveness.
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Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.
