It’s new year time – a time to sit back and look into the past, learn from the mistakes and plan for the future. And enjoying in the present (most important though).

 

Amidst the Omicron scare, a hawkish monetary stance of the Fed, USA and RBI in India to tackle rising inflation, the market is highly volatile. With crores of investors wealth eroding in a few minutes, Dec 2021 is turning out to be quite a conclusion to the already eventful year 2021.

 

When the market corrected, it gave a jolt to the ‘perpetual motion machine’, a notion that financial innovations and the concept that “this time, it is different” could increase accelerated wealth. However exciting it may sound, this ‘perpetual motion machine’ violates the fundamental laws of physics.

 

Likewise, it is an impossible dream for an economy growing at a nominal growth rate of 10% to 12% to offer a universal profit of 15-20% per year. It violates the simple mathematical rule that the overall wealth growth rate equates to the economy’s growth rate.

 

Nonetheless, some sectors like digital can exhibit transient accelerated growth due to innovations and discoveries. In the end, global wealth appreciation has to equal GDP growth. The challenge is often to accept the losses and realize that the previous gains were not real but were inflated values

 

 

The time evokes memories of the 1929 stock market crash and the dot-com bubble.

 

Americans participated in the stock market with borrowed money leading to an astronomical rise before the crash – The great depression. Rising prices created a positive feedback loop, encouraging people to continue to invest more and more.

 

With the dawn of the millennium, the belief that the Internet and the knowledge economy has the power to transform both society and productive possibilities fundamentally gained tremendous ground.

 

In its most extreme form, it was a belief imagining a kind of “digital sublime” that promised almost unlimited wealth. A strong bull market in the 1990s existed, particularly for technology stocks. Investors allocated a higher percentage to such shares and invested in riskier (often technology) companies.

 

The bubble and crash were apparent in the case of technology stocks. The NASDAQ index rose more than six-fold between 1995 and early 2000 and lost more than three-quarters of its peak value by late 2002.

 

 

Robert Shiller described the psychology of the market in late 1990 in terms of irrational exuberance. Though the firm’s current earnings did not seem to be a valid basis for high stock prices, investors thought future earnings would grow at rapid rates.

 

The internet stocks attained celebrity status, with their prices exceeding intrinsic value, similar to the celebrities who earn more than the individuals’ talent, owing to a strong emotional dimension.

 

Just as the media promotes celebs, it glamorizes investing/ stock market trading. Familiarity heuristic led people to prefer to invest in things they think they know and understand. Many people began to use the Internet during the internet stock bubble, which felt familiar to them. The Internet appeared to offer immense potential. Conceivably, internet stocks came to be seen as exciting investments with huge potential by association with the Internet itself.

 

After stock price increases, the investors are less risk-averse because prior gains cushion subsequent losses. The result is higher volatility in stock prices. Changes in attitudes towards risk significantly affect asset valuation and price changes. Risk aversion among investors increases after stock prices fall, which reinforces the drop in prices

 

Momentum played a significant role too. The investors were divided into fundamentalists (price traders) and trend followers (herd traders). The fundamentalists believed in the mean-reversion of stock prices towards a true (fundamental) value. Any deviation from the true value would be corrected. The herd traders thought that a direction of price movement would continue. The number of investors in the two groups varies over time. Before the market falls, the proportion of trend followers often exceeds the fundamentalists.

 

In addition, herding is often rationalized based on the “new economy”, new “real option” valuation. Moreover, a sense of safety of numbers – everyone cannot be wrong, offers comfort to the investors. Evolutionary psychology and neuroeconomics inform us that herding is one of the unavoidable consequences of our most potent cognitive ability, that is, imitation.

 

The increasing sheer complexity makes calibration of the risks from past data very difficult. In addition, the greater the complexity, the more considerable the variability in risk estimations. In other words, greater complexity introduces a substantial sensitivity to model errors, analogous to the greater sensitivity to initial conditions in chaotic systems. In a way, it is virtually impossible to put a valuation ceiling on the Cryptocurrency, NFTs, New age economy stocks.   

    

When reason becomes secondary to feelings, psychic realities govern the investment decisions. Wishful perception clouds the reality to accommodate what people want to see. This disapproval of the unpleasant truth diminishes the learning ability. I don’t want to sound like a pessimist but a realist. In the exuberance, don’t miss the red signals flashing.

 

 

Low-interest rates, stock valuations that tower over earnings, runaway retail trading, rapid accelerations in equity gains, and explosion in trading by amateurs are a few of the shared features between then (dot-com bubble) and now.

 

In 2021, excess liquidity, quantitative easing led to the market rise. But investors need to worry about 2022 if this trend can continue with central banks hawkish stance. A rebound from pandemic troughs was nearly inevitable, but a 2022 economy that looks much better than today is not.

 

 

As the year ends and we strut into 2022, it’s time to remind ourselves that greed, anxiety, moral hazard and psychological traits favouring risk-taking were there in the past and will exist in the future too. We have to decide whether we let loose them or rein them in the coming year. Beware of a “price-story-price” feedback loop that takes place repeatedly during a speculative bubble. 

 

Disregard the belief that the risk in the markets has vanished. Don’t be a Frog in the pan waiting for the water to boil. Stay invested in the market but shift money out of speculative stocks and into high-quality stocks as high growth companies with near-zero earnings will be hit the hardest. 

 

“History repeats itself, but in such cunning disguise that we never detect the resemblance until the damage is done.”  

 

Best Regards

 
Dr. Tarunika Jain Agarwal Ph.D.

 

Alpha Research