A long time ago, I took a course to prepare for the Series 7 Licensing exam. At the risk of divulging his identity, I will describe the instructor of this course simply as a former options trader closely affiliated with Ivan Boesky in the 1980s. We’ll call him “Jack”.

“I’m not a smart man.”

Jack would commonly make profound statements, and if you want to know the truth, I learned far more about trading strategies and mentalities from him than I ever learned about the recklessly boring material on the exam.

“…But I bought a boat this morning, and I did it at the expense of geniuses.”

From a man who claimed – and I believe accurately – that he made more money in a few years of cutthroat options trading on the floor of the exchange than he could spend in “five lifetimes”, I heard stories of greed, fear, panic, and the exchange of grossly profane language that accompanied each.

The most important aspect of trading that this man instilled in me was the idea that psychology means more than any balance sheet ever could. Let me give you a great example.

Fears, not diamonds, are forever

Diamonds are worthless. That’s right, I said it.

Think about it. Practically, what good is a diamond to anyone? The only conceivable use for a diamond is to construct something that is nearly indestructible and infinitely sharp (diamond knives are commonly used for the delicate process of eye surgery).

In the end of the day, you can’t eat a diamond. You can’t live in a diamond. Diamonds are essentially useless in the facets of everyday life. They’re only worth what people think they are worth.

To an only slightly lesser extent, the same comparison could be made to a share of stock. In other words, one could not take a stock certificate to the headquarters of a company and reasonably expect to turn in 100 shares in exchange for a desk and a chair from the CEO’s office.

It is psychology that drives the stock market and forces prices up or down. A share of stock is only worth as much as investors think it’s worth. When investors think a stock will go up, they buy. When investors think the value of a stock will decrease, they sell. Here’s the problem: when investors don’t know what a stock is going to do, they tend to sell also.

Hence the situation in which we currently find ourselves.

The market is dealing with a lack of confidence, which is a psychological issue. When this occurs, then perception becomes reality – it doesn’t really matter who makes or misses earnings, and what the government throws at the economy. Investors are scared, there’s a lack of trust, and when that happens, they pull their money out of the markets.

How the smart people are screwed

“A brilliant investor who cannot control his emotions is doomed to failure long before any highly disciplined investor with no brains to speak of.”

Jack knew, no matter how one tries to rationalize (let alone control) prices, it doesn’t change what’s happening. Swimming against the tide will drown you eventually.

The nurses that have applied the band-aids to the economy lately (Hank, Ben, and friends) are smart people. Academically.

There are tons of investors from MIT, Harvard, and University of Chicago pining over numbers, P/E ratios, and dividend yields in a desperate attempt to ascertain a reasonable valuation for whichever stock is in front of them.

And they’re losing money. Why? Because whether the stock has a P/E ratio of 100 or 13, it’s still overvalued if people are afraid of it. All the research in the world won’t save a stock that investors are nervous about. Especially when we’re inherently taking the company’s word that their financial records are in order.

Picture a group of people in a crowded bar. A fire ignites behind the bar. In reality, it would make sense for someone to grab the fire extinguisher, but tell that to the 180 people stampeding out the door because they’re afraid the liquor will ignite.

Come grab a few drinks at the US Market Tavern.

The aftermath of the fire

As a huge fan of technical analysis, I am telling you that those people who rely only on these technical aspects, their systems and theories, and refuse to believe that they are wrong (which many tend to do), will – if they haven’t already – be getting their rear ends handed to them.

Take Jack’s advice and look at what’s in front of you. If the market’s dropping, don’t argue. No one will listen. Instead, keep a cool head and position yourself on the other end of the panic. And turn off the screaming idiots on CNBC who get paid to create and sustain fear.

John K. Whitehall
Analyst, Oxbury Research