Rational Investing: Bear market unveils lesson in psychology

It’s usually the result of a combination of factors, such as the media talking about market highs, Wall Street flush with rosy outlooks and the talk at parties centering on fast profits that several in attendance made. (Think the tech bubble.)

Unfortunately, that is the period in the market when that euphoric feeling leads many to reverse the old adage about buying low and selling high. It is very easy to get caught up in the excitement of markets rising.

That’s one end of the cycle. Let’s look at the other end, where those same investors are selling with abandon. It is at this level that the serious investor kicks in his acquisition prowess extolled in the saying that, “You make money in bear markets – you just don’t know it until later.”

Last month, we discussed this level in the market, with the opinion that the mood was so negative, the news so unrelentingly discouraging, the rush to cash so fevered, that we were likely near the bottom of the correction.

So what has happened since then? For starters, the financial system has not collapsed, in spite of the drumbeat of news about its imminent demise. That news, and those many talking heads on CNBC, spoke doom and gloom as though the Federal Reserve could not have a positive impact on the situation and the leaders of most of the major financial institutions were clueless and operating in a static, no-way-out condition.

Is it over? Is the financial system finished seeing write-offs and earnings disappointments? Nope, not at all. But a funny thing happened on the way to Armageddon: The Fed took significant action to provide liquidity, the financial institutions developed sources of balance sheet strengthening,and

s-l-o-w-l-y, the mood of the investing public took notice.

The result is surprising many who look at the markets in terms of what happened in the past rather than consider what may happen in the future, and fail to grasp the market’s forward-looking discounting mechanism.

It’s easy to become entangled in such confusion in the moment-by-moment and day-by-day fluctuations.

In such befuddlement, the cycle completes itself, the emotional apogee of the euphoric buying state falling to the emotional perigee of distraught selling.

Guess what? That’s when the smart money – the investors who know how to understand balance sheets and income statements and can determine intrinsic value – position themselves for future profits.

Where are smart investors looking now? Based on the aging population (6,000 baby boomers are reaching retirement age every day) the growing need for energy, the expanding need for health care services, international emerging economies and shortages of many natural resources, they are evaluating industries in those areas.

They also are looking outside the Unitied States at the growth potential in foreign economies. But they are neither buying companies willy-nilly in those industries nor are they tossing money indiscriminately at foreign index funds or exchange-traded funds.

They are using rational analysis and patience. They are looking at companies with growth rates greater than their price-earning ratios, with low debt levels, sound dividend payout ratios and in which institutions are not yet dominate holders of the stock.

They are looking at U.S. companies that have a substantial amount of their sales and earnings generated outside the country. They are looking at ETFs that have broad diversification within countries whose economic growth rate is greater than ours.

Most of all, regardless of their selection and regardless of the amount they have to invest, they are doing so rationally, understanding that the vagaries of the market will create a lot of “noise” from time to time, but reason and patience will create a lot of profits.

They are buying when many are selling – and will be the sellers when the novices are satisfied that the economic and market problems are finally resolved and enter their euphoric buying state.

Setting aside all the financial aspects, isn’t it an interesting study in psychology?

Clark Davis is a 37-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company. He can be reached at cdavis@slia.com.