So says behavioural finance analyst Ken Norquay. “I recommend selling your long-term financial stocks before the next stock-market down wave begins.”
In past articles, I have referred to certain investing techniques as ‘market psychology’. A more contemporary term is ‘behavioural finance’ or ‘behavioural investing’. Some investors find it difficult to grasp this concept because it is difficult for some of us to assess our own feelings. Some go so far as to suppress the very idea that investor emotions can influence financial markets. In this article, I will use the behaviour and emotions associated with the current global pandemic to illustrate some important factors in behavioural investing.
Consider the concept of social distancing. Experts tell us, based on logic and common sense, that if we keep a distance of 2 metres between ourselves and others, the odds of catching the COVID-19 virus are reduced. Many governments have instituted regulations to help people comply with this rational idea. But some individuals and some societies find this difficult to accept.
For example, Latin cultures like to hug and kiss each other a lot. Secondly, American culture has a high regard for rebels and rugged individualists who defy ‘the rules’. As a result of these cultural differences, there are differences in the rate of spread of the virus in compliant vs. non-compliant countries. In that sense, the spread of COVID-19 is seriously influenced by our collective behaviour. Some would say that the spread of the disease actually measures the degree to which a given society is compliant.
The Elliott Wave Theory
The mathematical model used to study the spread of disease through a population is the same as for the spread of a financial idea/mood through a population of investors. That model is called Elliott Wave Theory (EWT). EWT became popular as an investment tool after American Robert Prechter and Canadian Alfred John Frost published their book, Elliott Wave Principle: Key to Stock Market Profits in 1977. It wasn’t until years later that a medical doctor from Buffalo, New York, specializing in infectious diseases, observed that diseases spread through populations in EWT patterns too. When we hear reports of COVID-19’s ‘second wave’, it is the Elliott Wave model to which they are referring. Clearly, both infection rates and stock market trends are reflections of human behaviour.
In the same way that there are compliance-based cultural differences in the world’s population, there are risk assessment differences in the investment community. When we write about investor optimism or pessimism, we are referring to investors’ attitude toward the inherent risk in stock market investing. At tops, investors are mostly optimistic. At bottoms, mostly pessimistic. It is the declining stock market that changes their mood.
The same is true for the pandemic: as the disease spreads, non-compliant people change from non-compliant to compliant in the same way as optimistic investors turn pessimistic. The model that best describes these changes in behaviour over time, is Elliott Wave Theory.
The details of EWT are beyond the scope of this article, but I will summarize briefly here. The longest bull market in US history ended on February 19, 2020, and the ‘Triple Twenty’ bear market began the next day, on 02/20/2020. It will unfold in at least three Elliott waves. The first down wave ended on March 23, 2020. The market is now in the second wave, a strong upward rebound. When that up wave is complete, the most serious part of the down trend will begin. That down trend is the wave that converts the optimists into pessimists and reduces your equity mutual funds to a mere shadow. After that, there are a number of possibilities as the decline approaches its end.
The Federal Reserve Board, the Bank of Canada and all the other central bankers are well aware of these behavioural finance theories and are doing their best to help people maintain a positive attitude toward the economy. I encourage you to maintain a positive attitude too. ‘Positive’ does not mean ‘optimistic’. ‘Positive’ means ‘realistic and practical’. We all see an economic storm coming. We must take the appropriate precautions. When the market bottom arrives in a few years, we’ll re-establish our stock market position. All this, with a positive mind.
Maintaining this positive mind, let’s review our usual financial trends and adjust our asset allocations to reflect the reality of other people’s collective financial behaviour.
The Long-Term Trend is Down
Canadian and US stock markets The first wave of the long-term down trend lasted 23 trading days, 33 calendar days, and dropped the S&P500 by 35 per cent. The subsequent rebound has neutralized most of the loss. In Toronto, the TSX Composite dropped 38 per cent and also gained back much of the loss. In my introduction, I explained what we should expect next. For readers versed in Elliott Wave Theory, we expect an initial A-B-C decline: the B wave is nearing its end. (For the record, we do not expect a simple A-B-C decline, but a long, complex bear market that will continue until systemic reforms are made to the world’s debt-burdened banking system.) The long-term trend is down.
Canadian and US bond markets The high in bond prices (low in bond yields) occurred on March 9, 2020. Prior to the extreme volatility in the financial markets in March, we had rated the bond markets as neutral. But that spectacular upward jolt, followed by an even more spectacular downward jolt, followed by another upward jolt, led us to declare March 9 as the top. This is a ‘low confidence’ call because the US Federal Reserve Board (the FED) is interfering with the free markets by its massive ‘we’ll-do-whatever-it-takes’ bond buying binge. The FED is printing money. Anything can happen. But we know one thing: bond prices are lower now than they were at the March high. For now, the long-term trend of bonds is down.
US Dollar vs. the basket of non-US currencies The US dollar has been going sideways since late 2014. On a short-term basis, it too participated in the first quarter volatility, moving from a low of 95 in early March to a high of 103 in late March. It has settled back to 96.5 for now. The long-term trend is neutral.
The Canadian dollar vs. U.S. Dollar The loonie has become a petro-currency again, matching trends with the price of oil. The long-term trend is slightly down. The short-term trend is up. (Read this in conjunction with the analysis of oil prices.)
Oil prices The long-term trend is down, but the main financial feature of this crucial commodity is the huge multi-year fluctuations in price. A huge multi-year down trend appears to have ended, but it is still too early to know with confidence. In the first quarter of 2020, oil dropped sharply. Now, it has rebounded, recovering about half of that decline. During the extreme pessimism of late April, certain oil futures briefly turned negative. This pessimism was an important indication of a possible long-term bottom in oil prices. The long-term trend is neutral for now, but may soon become a down-to-up trend reversal.
Gold prices Gold is in a long-term uptrend. In the short term, gold has accelerated upwards as the US dollar has cooled down. The uptrend has attracted significant attention from mining stock promoters and other speculators. Expect a multi-month cool-off period once the current speculation ends.
Investors who love Canada’s financial stocks should be wondering why, in the big sell-off early this year, the financials went down more than the TSX composite. What do big pension fund and mutual fund managers anticipate that optimists do not? Why did they sell off these ‘darling stocks’ more aggressively than they sold average stocks? Furthermore, why has the Financials ETF (TSX—XFN) recovered only 46 per cent of its loss, when the TSX 60 ETF (TSX—XIU) has recovered 68 per cent?
What potential problems do those big money managers see that average investors do not see? I recommend selling your long-term financial stocks before the next stock-market down wave begins. Once you have sold, you can guess at what those future financial stock problems might look like. As long as you own financial stocks, you won’t be objective. Your behaviour will be to look for reasons why your beloved financials will rise. Once you’ve sold, your investment vision will be clearer. That’s how behavioural investing works.
Ken Norquay, CMT, is the author of the book Beyond the Bull which discusses the impact of your personality on your long-term investments: behavioural finance. He can be reached at firstname.lastname@example.org.
This is an edited version of an article that was originally published for subscribers in the August 2020/FirstReport of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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The MoneyLetter •9/10/20 •