Making Sense Of Stock Market Behavior

by | Jun 1, 2020 | *Financial Awakenings, Financial Therapy, In The News, Investment, Money Psychology, The Economy, Weekly Column

One of the most asked questions I get is, “Why is the stock market going up when the economy continues to get worse? This makes no logical sense.”

More workers file for unemployment every week. Over 20% of our workforce is unemployed. Name brands like Hertz and J. C. Penney join the increasing number of companies filing for bankruptcy. The outlook for small businesses that deal with consumers is increasingly pessimistic. A vaccine for the virus won’t come until 2021, if we are lucky.

And in the face of all that, the worst economy since the Great Depression, the stock market is up over 30% from its recent low. Why? It’s confusing.

My short answer is, “This is what the stock market often does in the face of reality, exactly what we don’t expect it to do.” Human behavior is the driver of financial markets. At first glance it appears that the rise or fall of financial markets often makes no logical sense, just in the same way that human behavior often makes no sense.

Yet financial therapy teaches us that all irrational financial behaviors, no matter how illogical they may seem to you or others, make perfect sense when we understand the beliefs behind them.

History suggests it is not logical for a person to sell out and go to cash when their financial portfolio is declining in value. In fact, the further the decline in the portfolio the more illogical it is to sell out. Why? History shows that, in time, financial markets almost always rebound. Perhaps specific securities may never rebound and actually go bankrupt, but the general market almost always recovers. So the lesson from history is that when financial markets go “on sale” it’s a time to buy more, not sell.

However, that belief that something is “on sale” is true only if the price reduction is temporary. If you believe the price drop is temporary, then there is plenty of incentive to “stock up” because buying at the new price represents a “deal.”

If you believe the price drop will last, though, buying at the new price doesn’t represent a “deal” because the “deal” will be there far into the future. There is no reason to buy unless you need that product or service today. The incentive might be to wait to buy it until you absolutely need it, because “tomorrow it will be cheaper.” Further, if you have a lot of the product, it may make logical sense to sell any surplus today, because you can buy it back for less tomorrow. This is classic deflation, expecting a product or service to cost less in the future. Inflation is the opposite, where the future cost of a product is assumed to be higher.

When the stock market falls, and the belief is that the reduction is “permanent” and the price of a security will be lower tomorrow, it makes perfect sense to sell everything, because tomorrow it will be worth even less. When you combine that belief with a strong dose of fear of becoming a bag lady if your financial portfolio declines much more, selling out is even more understandable.

In short, stock markets fall when more investors believe prices will be lower rather than higher tomorrow. Markets rise when more investors believe prices will be higher tomorrow rather than lower. Both of those beliefs are anchored in tomorrow, not related to what is happening today.

Financial markets commonly ignore the present and focus on what investors believe the future holds. When viewed in that light, stock market increases and declines are always logical.

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