Market sentiment, the power of psychology

While well-educated analysists and accountants pore over EBITDA and myriad other figures, meanwhile the stock market does exactly what it wants to do. A news item today might spur the market higher, but the same news on a different day may cause the exact opposite reaction.

So how do we solve this enigma to our benefit? If university degrees and diplomas were the key to market success, we would not see so many of the world’s eccentric but richest and most successful traders taking home the bacon. As they do, constantly.

So there is something else at work here, what is it?

In a word; Sentiment. It is the most powerful market driver, and one of the least understood.  

It takes years of experience for the penny to drop on this. The market is very perceptive, and one of the keys is that we can always assume that, left-field events aside, everything we read or anticipate is already in the prices.

We hear phrases like undervalued, overbought, and others, that are really meaningless. A stock’s price can stay undervalued or overbought for years, without it ever coming into ‘balance’. Tesla was overbought at $100. Similarly, we may read a positive item in the press, but of course, the stock price will already reflect this. Tesla is actually a good example of the power of sentiment.

The true price is the one you see, here and now.

The actual stock price is the average of what everybody in the stock thinks of it, right now.

This is useful for another purpose. Sometimes we will read really bad news, which a reasonable person might think would have a serious effect on the price. But for some reason the price does not drop? What does this mean? It means that the collective wisdom of all shareholders, and would-be shareholders, has decided that the news is not so bad at all. So when a doom and gloom journalist writes a negative story and the price does not drop, my money will always be on the very positive sentiment that this confirms. This perception is especially useful when the market is in a major sell-off and a few stocks refuse to drop. They are the stocks I will buy, not the ones that have had the biggest drops and are a ‘bargain’’. A stock is worth its actual price, so I either buy at the current price or higher, I never place a lower bid, because if it does drop, that confirms that the train is indeed going in the wrong direction.  I don’t want to be there.

There are many other indicators of sentiment. One important one is ‘skin in the game’. If the founders or senior directors own a large portion of the company, it pays to listen very carefully to any statements they make. There is no better example of this than Fortescue Metals. The founder owns more than one third of this huge company. Its his baby. I was fortunate enough to be a student of the company when it was little more than a thought bubble. During that period the founder made several innocuous statements that were missed by the press and most people. One important one was that he said the capital of shareholders would never be diluted. He being the biggest shareholder, this statement carried a lot of weight with me. So what happened? Well the company got itself in to a massive debt, and falling iron ore prices made it look very precarious. In moved some of the big American professional short sellers, in the hope that Fortescue would be forced to make a cheap share issue to raise cash, that would enable them to close their shorts at a great profit.   

What happened? The founder and now Chairman who made the statement about no dilution came up with a plan that not only pushed the debt out a few years but also renegotiated better terms. There was no issue and no dilution. The shorter retired, badly hurt. I cannot emphasise the importance of this aspect too much. For example, if the CEO of BHP made such a statement, it could not be guaranteed beyond his tenure in the job. So I pay great attention to the connection between the company and its biggest holders.

Another good example of this phenomenon is Tesla. Shorters attacked it from a few hundred dollars, constantly dwelling on the fundamentals, poor sales numbers, high costs, and more. But the elephant in the room escaped the notice of many of these traders. It was Elon Musk’s baby, and buying shares in Tesla was really buying shares in the brain of Elon Musk. It was so obvious that he would come up with other associated ideas that would justify the massive share price.

There are research websites that show how much ownership the managers and directors retain. A very valuable resource.

After many years as a student of market psychology, I have come to place management at the top of the list. A good manager can rescue a poor company from the gutter, and a bad manager can destroy a good company. There is a perfect example of this in one of the big banks. The CEO who rose from a teller with a small shareholding went to sleep on the job and lost the bank $US4 billion. Simply because he was not aware of a mistake that compounded rapidly. He was removed, after being rewarded with a golden handshake. He then went on to manage another smaller company. Within a year its price dropped from $1.10 to ten cents. The bank has never really recovered its prestige even after twenty years.

So if his name popped up on a board of directors somewhere, I would stop reading.

A friend of mine invited me to a private ‘sales pitch’ of a new listed  IPO company. He had put in $300,000. The sales pitch went very well with lots of very impressive, coloured slides. The fundamentals were wonderful.

But I drew my friend’s attention to something that I unearthed with a bit of research. The Managing Director had only a few years before, been declared bankrupt after a previous venture failed. My friend was undeterred, and within a few months watched his $300,000 totally evaporate.

Then there are other companies that operate in parlous industries where success is very hard to achieve, eg, airline companies. One in particular in Australia has a ‘silent’ chairman who rarely speaks, but who has a large shareholding, and a steely determination to make it work. Financial journalists rarely ‘google’ information on such uninteresting people (see ‘silent’ above). This particular invisible silent chairman has a massive success rate in his other business interests. Uninformed critics constantly predict the airlines’ demise, and have been doing so for years. Meanwhile, it carries on with an enviable profit record in a most difficult industry. It is faintly amusing to watch its main competitor who is 40 times bigger, tie itself in knots over the persistent little annoyance. All of this paragraph is reflected in the fact that its share price remains stubbornly strong. In other words, it is a classic example of market psychology at work.

So, sentiment, ownership and management are my mantras. Positivity in those three can overcome debt, pandemics, and persistent attacks from journalists and politicians.