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Measuring investor mood – in Waves

Posted by: Brian Dennehy
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Membership level: Free
 
Warren Buffet is the world’s most successful investor, and his first rule of investing is not to lose money. Learn from him.
 
For you, this means having good money management or risk management - it is your defence if you like. There are two vital elements to this:
 
Firstly, the cash level in your portfolio, which I will look at now, and then your stop-loss (there is much more detail on this here).
 
Over a lifetime of investing, most of the time the amount you hold in cash will be limited – it might be enough to cover fees, and include some dividend payments – say up to 5% of your portfolio value. But from time to time you should increase this.
 
Every few years, a stock market uptrend morphs into a mania. This doesn’t happen overnight, and the indicators of a mania will grow, often over a period of years. 
 
Taken together these indicators help you take the temperature of the market – some of them measure valuations, others the behaviour of investors, and in all instances, you will want to see evidence of extremes before increasing your cash position.
 
One particular indicator provides a visual sense of the psychology of the crowd of investors – from confidence, to over-confidence, to mania. It is Elliott Wave Theory, which breaks down the stock market gyrations into waves of confidence. Gold Members who have been with us for a while will know all about our Elliott Wave analysis. For those newer members, here is a refresher:
 
In the 1930s a gentleman called Ralph Nelson Elliott noticed that apparently random stock market moves appeared to have some predictability. The mood of the herd of investors appeared to move in patterns, or waves, which kept repeating.
 
He noted a complete market uptrend or bull market breaks down into 5 waves: three up and two down. Each wave has its own personality.
 
For example, wave 3 is typically long and exciting - confidence builds persistently and the herd of investors grows. This is where the big profits are made.
 
It is during wave 4 when cracks appear in the optimistic case, and “the smart money” takes profits. In wave 5 the latecomers, sometimes called “the dumb money”, start buying for the first time, and less experienced investors stay on board, not understanding the warning bell rung by wave 4.
 
This form of analysis is something which we have referenced for 30 years at Dennehy Weller & Co. It has limitations of course - but it has also been a valuable guide over a very long period. 
 
It was at the heart of our 1998 report highlighting the coming crash (1999-2003). It featured again in our January 2018 research, with analysis of what lay ahead in 2018/19 which, though not perfect by any means, you will find difficult to beat - we would say that of course!
 
To download that report, click here.
 
We focus on the US stock market for three reasons:
  • It is the pivotal global market – where it goes, we must assume most other markets will follow, including the UK
  • It is very over-valued, and displays a number of “mania” indicators
  • It currently has the clearest Elliott Wave structure since the lows of March 2009
There is no single point at which anyone can say “this is THE top!”. It is not possible to forecast with that degree of accuracy. It is like hill walking – there can be numerous false summits. So as the picture of over-confidence and mania builds, you gradually increase your cash position.
 
For example, by the second half of 2018 the advisory clients of Dennehy Weller & Co were typically 20-30% in cash. By the Summer of 2019 this was frequently nearer 50%.
 
Now look at the chart 1 below. The top graph shows the uptrend of the US stock market since the low of March 2009, with Elliott Wave numbers. For context, the bottom graph is an idealised version of an Elliott Wave uptrend or bull market. Remember, there are 5 waves in total, three up and two down.
 
That top graph is the pessimistic case. It assumes the complete uptrend since March 2009 is over, and that the US market is heading back towards those lows of 2009 – a fall of 55%-80%.
 
But this is art not science – I certainly keep in mind the possibility of those false summits. The vulnerabilities that we have talked about regularly are facts; valuations, volume of debt, liquidity, computer trading, Trump. But the timing and extent of falls are not known. This means visualising more than one possible outcome.
 
For example, until the coronavirus took hold, a fall of 25%-30% was the most likely outcome. This would mean a sharp fall, over in a few months, and then a rise to a new high, perhaps in 2021, to complete the whole uptrend since 2009.
 
The latter is now the optimistic view – and is still perfectly possible. But the nature of the coronavirus, and its potential impact on already vulnerable financial markets and banking systems, has meant that you now have to put the pessimistic case front and centre of your thinking, and allow for it in your planning.
 
FURTHER READING
 
The Pessimistic Case
Topic: Portfolio building


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