You Can Profit From Mr. Market’s Mood Swings
"Be fearful when others are greedy, and be greedy when others are fearful."
- Warren Buffett
What a difference two weeks make...
Until January 29, U.S. stock indexes were hitting record highs day after day.
Both the S&P 500 and the Nasdaq had soared by 40% or so since the election of Donald Trump.
On Friday, January 26, the S&P 500 peaked at 2,872.87.
Then the financial markets fell apart.
On February 5, the Dow tumbled 1,175 points - its worst point decline ever and the fourth-fastest correction in history.
And by last Thursday, it had closed a total 10.2% lower...
Financial pundits had a field day.
Cassandras warned that it was the bear showing the first of its sharp claws.
Optimists opined that the swoon was merely a well-earned breather in the inexorable upward march of the markets.
The Death of Homo Economicus
I believe that the financial markets are one giant Rorschach test - you know, the test where a psychologist asks you to make sense of an oddly shaped inkblot.
Put another way... you see what you want to see.
My view flies in the face of conventional financial theory taught by professors in business schools around the globe.
Contrary to Nobel Prize-winning economic theories about "rational expectations," an investor is anything but "homo economicus" - the perfectly rational actor you'll meet in every finance textbook.
Like Bigfoot, an "economic human" has never been seen in real life.
Unlike you and me, homo economicus...
- Has perfect information for investment decisions
- Does not feel emotions like fear and greed
- Believes that financial crashes like the one in 1987 happen only once every billion years.
Of course, I'm hardly the only homo economicus skeptic.
Psychologists have long confirmed that we humans suffer from cognitive biases that make it difficult for us to win in the markets.
Academics have labeled this new field "behavioral finance."
Not surprisingly, it took psychologist Daniel Kahneman to convince economists that investors don't act like hyper-rational automatons.
In a slap in the face to the entire economics profession, Kahneman won the 2002 Nobel Prize in economics without ever having taken an economics course.
Putting Mr. Market on the Couch
Try telling a street-smart trader you've just learned that investors aren't perfectly rational...
And he'll look at you with both pity and disdain.
After all, traders do little else than pay attention to the market's mood swings.
Warren Buffett said that one of the most important lessons he learned from his mentor Benjamin Graham was the parable of Mr. Market.
Here's how Graham described Mr. Market in Chapter 8 of The Intelligent Investor...
On some days, Mr. Market is euphoric. On other days, he’s very depressed. If you catch him on a good day, he wants a very high price for his shares. If he’s in a down mood, he’ll sell you his shares for a pittance.
Mr. Market highlights the one thing you can predict with certainty about financial markets: Investors always overreact.
Last week, Mr. Market shifted his mood from go-go optimism to extreme pessimism for no real, discernable reason.
Now, I don't know how Warren Buffett is reacting to Mr. Market's current mood swings...
But I do know how he has reacted in the past.
In August 2011, the U.S. stock market sold off sharply, much like it did last week. Investors panicked after the U.S. lost its AAA rating from Standard & Poor's, the world's foremost credit ratings firm.
On August 25, Buffett publicly announced that he was aggressively buying Bank of America (NYSE: BAC) stock.
Fast-forward six years to July 2017, and Buffett had almost tripled his money.
Once again, Mr. Market's mood swing proved temporary.
Today, I bet Warren Buffett is already on the hunt for his next big bet on an oversold stock.
Be like Buffett - don't get caught up in Mr. Market's latest mood swing.
Instead, pause and reflect...
And take advantage of the opportunities the market pullback offers.
Here's my prediction: The U.S. stock market will bounce back quickly from its current correction.
After that, it'll be a stock picker's market between now and September.
In October, we'll see the traditional fourth quarter rally in global stock markets.
And by that time, Mr. Market's current mood swing will be a distant memory.
Thoughts on this article? Leave a comment below.