The Pervasiveness of Investor Overreaction

Overreaction is one of tiie most predictable features of marlcets. In chapter 16 we will look at the amazing similarities between the overreactions in the IPO and aggressive-growth markets of 1977 to 1983 and 1991 to 1997. Investors in the market of the nineties bought almost the identical stocks, for the same exciting reasons, as die ones that were massacred a decade earlier. Only this time the excesses were more exti-eme, and the correction even more severe. On July 10, 1996, Nasdaq took a larger intra-day drop than the day of the crash in 1987. Such high fliers as America Online plummeted from $78 to $38 (where it still was priced at a modest 166 times eamings), and Presstek from $200 to $58 (still 212 times eamings). And that was for openers. The second wave beginning in the fall of 1997 began to take many of the major winners apart.

We noted in chapter 9 how people frenziedly flocked into emerging markets in the 1990s. Again no price was too high to get into the Hong Kong and other Pacific Rim markets, or into Russia, the former Eastem Bloc, or Latin American stocks. The stock indices of these countries soared. Billions of dollars pouring into illiquid markets again made increase in prices a self-fulfilling prophecy-for a while.

As we also saw in chapter 9, by late 1997 the emerging Asian markets dropped 8 1 , the South Korean market reaching a 10-year low. Such reactions are a way of life in markets, even for the bluest of the blue chips. They prevent investors from seeing opportunities when they almost stumble into them.

In August of 1982, investors and the media were extremely bearish on the stock market only weeks before the great bull market began that lifted the Dow Jones Industrial Average more than ninefold. Again the negative sentiment was enormously ove layed. By many standards stocks were at their lowest levels since the 1930s. But because prices were actually below where they were 12 years earlier, people could not see the vast potential in equities. This overreaction caused them to avoid the stock market like the plague, even though stocks were in the bargain basement. The Dow, adjusted for inflation, was under 80, not far from die lows of the Great Depression, while book value, according to John Templeton (again adjusted for inflation), was at a greater discount to market price than at any point in the century. There was exceptional value out there.

Investor overreaction, this time on the negative oudook for stocks, resulted in the majority missing the greatest stock market opportunity in several generations.

At the same time, bonds were cheaper in real terms than at any time in 100 years. Another overreaction was also taking place concurrently with the blacklisting of stocks: the almost paranoid fear of long-term bonds, even though their value was unparalleled. Such reactions can often be captured while they are unfolding, if you are aware of some of your cognitive and other psychological limitations.

The reactions are almost almost always accompanied with headlines, ebullience, or fear. Interest rates, said West German Chancellor Helmut Schmidt in 1982, are "higher today than at any time since Christ walked the earth." It was the opportunity of a lifetime for brave investors who could step up to the plate to buy something that had done badly for the past 30 years. Bond prices had not only discounted all the negatives that had already happened, but a carload of negatives that never would happen.

Almost everyone back then thought that bonds were a terrible long-term investment, good only for the occasional trading profit. But experience teaches us that when "everyone" comes to the same conclusion, that conclusion isjust about always wrong.

Only months later investors took a dispassionate look at the available values in the bond market and prices went through the roof. People who recognized this major overreaction and acted on it made a bundle. Thirty-year, zero-coupon treasuries, for example, appreciated over 100% in about 6 months.

But a caveat is in order here. Seeing an overreaction and acting on one are two different things. If you can act on it you can make major money, but its a heck of a lot harder than it looks. Too, there is the small matter of timing. You may be dead right on the overreaction, but way off on the timing. Take a call made on the Japanese market in 1987.

The Japanese market seemed not just ove riced, said an observer, but was at the mania stage, ranking with tulip fever or 1928/1929 in its speculative frenzy. Why was he sure? Because the symptoms of all manias are remarkably similar. Just as remarkable, in every case the idiocies are generally overlooked until after each bubble bursts.

To tick off some of the major symptoms:

1. Absurdly high prices. The average P/E of the Nikkei 225 was 86 times estimated 1987 earnings. (The peak for the U.S. market in 1929 was 20 times.)

2. Experts on the Japanese investment scene wrote that the market was shooting skyward because of a shortage of stock. This argument was identical to the one used to explain why the market would continue

to rise for years to come by some of the most important players in the late twenties, according to J. Kenneth Galbraiths classic The Great Crash-1929.

3. It was more profitable to speculate than manufacture. An estimated 20% to 30% of Japanese 1 profits came from stoclc-marlcet trading. The situation was similar to tulipmania, in which Dutch industry and commerce slowed down so that merchants could pick off far easier profits from tulip bulbs.

4. Japanese institutions were large holders of stocks and would never sell. Ha! So were the vast U.S. trusts of die late 1920s, undl the market unraveled and everyone ran for his life.

5. "The Japanese market was unique," stated experts, and "this uniqueness will lead inevitably to higher prices." The identical statement has been made in every mania in financial history.

Well, the observer-who happened to be me-was almost right. The prediction of the Japanese market being overvalued was dead on. However, it was a mite premature-the statement was made on August 24, 1987, when the Nikkei 225 was at 25,760, and it rose to over 38,000 by 1990, some 50% higher, before it blew apart. And-oh yes-there was another slight problem with the forecast. It assumed a Japanese crash would come before a setback in the American market. We had a minor one that year that saw U.S. markets plummet 33% in mid-October.

Theres a lesson to the story. Overreactions are very predictable using the valuation guidelines Ive oudined, but actual corrections are impossible to forecast. Certainly all the telltale pennants were in place in the summer of 1987. Still, had an investor sold at that time, even though the market increased sharply, he or she could have rebought the same holdings 45% cheaper ten years later.

In the past few decades there have also been numerous overreactions in nonfinancial markets where investors rushed in only to have their net worth decimated. In the seventies, Chinese ceramics were increasing at a 23% annual rate, U.S. stamps at 23.5%, rare books at 21%, Art Deco at 19%, and old master paintings at 15.4%.

Faced with a stock market that was going nowhere, major economic uncertainty, and baffling inflation, people became more willing to speculate on the past, as represented by precious metals, jewelry, or artwork, rather than in the future of the American stock market.

This overreaction ended like all the others, of course, with collectibles and precious metals now worth a fraction of what they were at