Herd on the street: Time to think contrarian?

by Vivek Kaul/ DNA Money
“The crucial thing about the stock markets is that it is primarily driven by perceptions, not performance”. Late Harshad Mehta in an interview to Business Today in September, 1992.
Nothing’s fundamentally wrong with the economy. Nor is corporate profitability in any kind of bind. But the BSE Sensex fell by a whopping 1,111 points to 9,826.91 during intra-day trading on Monday (May 22, 2006), forcing a suspension of trading. Since May 10, 2006, the market has fallen by 16.9.%, after rising by 34.3% since the beginning of the year till May 10.
Sure, everything that goes up must come down, but why did this “correction” happen all of a sudden? Why did the market have to come crashing like a pack of cards? For an answer, we have to look at the history of bubbles and market mania.
Benjamin Graham and David Dodd, in their all-time classic Security Analysis, explain the way a stock market works. “The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather, should we say, that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion”.
Given this, at times the market moves like a herd. Robert Shiller, in his book, Irrational Exuberance, provides us with the answer on why this happens. “A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of times”. Psychologically, the desire to conform to the behaviour and opinions of others, a fundamental human trait, is what drives such buying behaviour. Like sheep in a herd, investors in a bull run find it cozy to be inside the herd rather than outside it. The Indian stock market has been going up for almost three years now, creating successes for some investors.
This has attracted public attention, promoting word of mouth enthusiasm and heightened the expectations of prices going up even further in the days to come. Price increases have led to more investors entering the market, fuelling an even greater price rise. But now that the market is falling, investors are again moving in a herd, pulling the prices down. The logic of the day is that the high prices are not sustainable since they are driven by unrealistic expectations of further price increases. The bubble now is losing air and prices are crashing. Nothing new. History is just repeating itself.
Whether it is stocks or anything else, the same investor psychology works. Charles Mackay, in his book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, published way back in 1841, described the tulip mania in Holland in the 1630s. As the story goes, in the year 1559, Councillor Hermart, a German collector of exotic flora, got a consignment of tulip bulbs from one of his friends living in Constantinople (now Istanbul). Hermart planted these bulbs in his garden in Augsburg, Germany. These tulips drew a lot of attention, particularly among the upper classes of Germany and Holland. By 1634, ordering costly tulips from Constantinople, had become increasingly common across all of high society in Holland. And this led to the prices of tulips touching the roof. With demand going up by the day, by 1636, the citizens started to trade tulips across many exchanges in Holland. And then the agents and speculators also entered the game. They would buy at the smallest drop in price and sell the tulips as soon as the prices rose. Given this, a lot of these individuals suddenly grew rich. As news spread, more and more people started entering this market.
But all so called good things come to an end. The prudent lot of investors started to realise that this could not go on forever. They felt that prices could not keep going up indefinitely and somebody would lose in the end. Over time, as this belief spread, tulip prices crashed, never to rise again.
Doesn’t this story sound similar to the current stock market crash? Something similar happened in Mumbai in the 1860s. The first land reclamation company in Mumbai, the Backbay Reclamation Company, was formed in 1864 and was promoted by Premchand Royachand. The company was formed on the logic that reclaiming land from the sea was the only way to tackle growing congestion in the city. The shares of this company were subscribed at a premium of Rs 21,500 on a face value of Rs 5,000. City traders were flush with the money they had made through the unprecedented rise in the price of cotton. This money went into speculating with shares of Backbay and other companies that were floated after the success of Backbay. At its peak, the share price of Backbay was quoted at Rs 55,000 – a record that probably still stands. Investors saw this as an opportunity to get rich quick and bought these highly overvalued shares.
At the same time cotton prices had been rising as Britain had been sourcing cotton from India for its Lancashire mills due to the civil war in America. The civil war ended and the news reached Mumbai on May 1, 1865. Britain would go back to sourcing cotton from America. This created a panic in the market and investors rushed to sell off the shares of reclamation companies, only to find that there were no buyers. Different story, same ending.
Such stories have been repeated over and over again. Be it the crash of 1994, when FIIs first entered India, or the crash of 2000-01, when technology stocks fell. The moral of the story: investors tend to move in a herd.

This is not to say that the current stock market crash is irreversible, because the economic fundamentals are still fine. But it needs an intrepid investor to think contrarian.

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