Trading on Emotion

I'm beginning to think one has to be bi-polar to be a stock trader these days. Oil hits a new record high, and the entire market rallies, led by Exxon. Never mind that record-high oil is bad for the economy overall. These days, the market is clearly trading on emotion, and looking for reasons to rally.

Tuesday of this week was proof of that, as stocks fell early in the day, with the Dow tanking as much as 200 points, until a late-day rally brought things back near Monday's close. The initial drop came as Fed Chairman Ben Bernanke (who is a pansy, by the way) told a group of community bankers that they should forgive a portion of their subprime borrowers' loan balances (I'll rant on that stupid idea later). Apparently, the market was concerned that doing so would hurt banks' profits, as they'd have to write down the loans.

Silly traders. Unless someone holds a gun to their collective head, bankers will do no such thing. So of course the market came back late in the day. Another thing that's been moving the market of late is the on-again, off-again mysterious Ambac rescue plan. CNBC first broke the rumor that a group of banks was working to bail out Ambac on Friday, February 22. The rumor sent stocks soaring in a late-day rally that saw the Dow climb nearly 100 points.

(Detour for the uninitiated: Ambac is the second-largest of the so-called monoline insurers. These companies traditionally provide insurance to issuers of municipal bonds, like your local school district or water district. That enables the issuer to get a triple-A credit rating, which in turn means they can issue debt at a lower cost. Their bonds keep that rating as long as the insurer is rated triple-A.

Trouble is, Ambac and its fellow monolines got greedy as the housing bubble inflated, and they started insuring subprime mortgage-backed bonds, at much higher premiums. When the bonds started to default, the insurers' losses were much more than they had anticipated, because - like everybody else - they mispriced the risk in subprime paper. Those losses are threatening the monolines' credit ratings, and if they all get downgraded - one already has been by one rating agency - so will the bonds they insure, which could trigger financial armageddon. In fact, one segment of the municipal bond market has already imploded, resulting in higher issuance costs for state and local governments. Bottom line: the markets would really like to see the monolines avoid a downgrade.)

Now, back to the Ambac rumor. Last week, CNBC said the plan had faltered, and we all saw where stocks ended the week. Then, this morning, after seeing the threat of a 200-point drop yesterday, CNBC leaks a rumor that the talks have resumed. But this afternoon, lo and behold, Ambac announces that it's going to attempt to issue $1.5 billion in stock. The market doesn't like the idea. Why? Because, while it would infuse much-needed capital into Ambac, who wants to buy Ambac stock? And is $1.5 billion enough to contain the additional subprime write-downs that are guaranteed to come?

So, the rally that had begun early in the day (on higher oil prices, again; in spite of morning economic reports that showed a possible second straight monthly decline in jobs, higher labor costs, and weaker factory orders) fizzled. At one point, the Dow was down about 75 points, after having been up as much as 115. But late in the day, it rebounded to close up 41 points.

Why? "After four down days, we had to take a rest from all that selling," one investment manager said. Oh. Okay.

Another thing that had fueled the early rally was the fact that a measure of the health of the service sector of the economy was higher than expected. Last month, when that measure dropped sharply, the market sold off dramatically, as it suggested widespread weakness in the economy (we already knew the factory and construction sectors were in the tank, but the service sector was our last glimmer of hope). So today, when it beat the forecast, that helped stocks - never mind that it was still below its neutral level, which indicates the service sector is contracting.

Herein, dear children, lies an important lesson about economic data, especially about market reactions to it when the actual numbers vary from the consensus forecast of economists. Too often, when a number comes out higher or lower than forecast, the market reaction is based more on the forecast than the absolute level of the number, like this morning, when the number was better than expected, but still indicative of weak economic conditions.

The theory is that the expectations are already priced into the market, but too often they're not. I don't recall the market selling off more when the forecast for the service sector gauge came out, for example. Yet we rally when the forecast is beat. But - and here's the lesson - what does it really mean when a number comes in higher or lower than the forecast?

All it means is that the forecast was wrong. In other words, a bunch of economists couldn't accurately predict what was going to happen. And this comes as a surprise? Look, the numbers are what they are. It's the forecast that's fungible. A weak number is a bad thing, and a strong one is a good thing, generally speaking. Bad forecasts are a given.

Back to stock trading and emotion. I recently came across a graphic that depicts relative levels of investor optimism, on a curve that looks like the letter S turned on its side, and backwards. The starting point is "Optimism," then the curve progresses upward through "Excitement," "Thrill," and "Euphoria," where it peaks. The decline passes steadily through "Anxiety," "Denial," "Fear," "Desperation," "Panic," "Capitulation," and "Despondency," where it bottoms out before rebounding through "Depression," "Hope," and "Relief," finally returning to "Optimism," at the same level where the curve began.

The interesting thing about this is not the progression itself, which is somewhat intuitive: sort of like Elisabeth Kubler-Ross' Five Stages of Grief. What's interesting is that the money managers who came up with the curve identified the point of maximum financial risk as the peak at "Euphoria," and the point of maximum financial opportunity as the trough between "Despondency" and "Depression."

In other words, when the market's riskiest, we're most euphoric about it, hopping on the rapidly-inflating bubble (or fast-moving train might be a better analogy) just before it bursts. Conversely, at the absolute best time to get into the market, we're so morose that we've finally cashed out and put what's left of our fortune in a shoe box in the closet.

The way stocks are trading right now, I'd say the market's firmly entrenched in Denial. Things are bad. They're going to get worse. But we'll find any excuse to manufacture a rally.