Investor Expectations Also Need Tapering As We Enter 2014

Psychologists say much of the reason investors have such a dismal record of buying high and selling low, of being excited and buying enthusiastically at market tops and then bailing out in disgust at market bottoms, can be explained by the ‘recency bias’ of the human brain.

That is we expect whatever happened most recently to continue, even though facts tell us it is unlikely. When a severe hurricane strikes in an area where such catastrophes are rare, even though experts describe it as a once in a hundred year event, we strengthen our preparedness on expectation of more such storms the next year. When those health warnings we had a month ago recede we forget about seeing a doctor since more recent experience is not alarming. When the stock market has been going up for several years, that recency has us forget the longer-term memory of severe declines.

Warren Buffett explained recency bias in investing in his warning in 1999 that the market was near a serious top saying, “Investors project out into the future what they have most recently been seeing. That is their unshakable habit, looking in the rear-view mirror instead of through the windshield.”

In 1999, they were looking back at the powerful bull market of the late 1990’s and projecting it to continue endlessly into the future. Instead, the severe 2000-2002 bear market took place, which those like Buffett who were looking through the windshield saw coming. After the bear market ended, it was still the scene in the rear view mirror for quite some time. And with fear having replaced greed, investors then extended its trend endlessly into the future even though the 2002-2007 bull market was underway.

Currently, seeing the wonderfully one-directional market of 2013 in the rear view mirror, and the five-year bull market beyond that, investors are obviously extending those trends in a straight line into the future.

Investor sentiment as measured by the Investors Intelligence poll of newsletter writers is at 59.6% bullish and 14.3% bearish. That spread between bulls and bears is an extreme ratio often seen near serious market tops.

This week’s poll of its members by the American Association of Individual Investors (AAII) shows investors are 55.1% bullish, only 18.5% bearish, and have 64% of their portfolios in stocks, just below the 69% stock allocation reached near the 2007 market peak.

The respected Ned Davis Research Crowd Sentiment Poll, a proprietary composite of numerous sentiment surveys, recently broke out above 70. That rivals some of its extreme readings of the past, and has Ned Davis Research Inc. expecting a 20% market decline sometime in the next 12 months.

Investors need to keep recency bias in mind as we enter 2014, since what is showing up through the windshield may be at odds now with the scene in the rear view mirror.

For instance, for the past five years the Federal Reserve has continuously increased its monetary QE stimulus. Beginning next month it will reverse the process to continuously decrease its stimulus.

For five years Washington has increased its fiscal stimulus, running the national debt into record territory in order to provide more spending, more support for the unemployed, more incentives for businesses to expand.

Washington is now also reversing that process. An estimated 1.3 million Americans will lose unemployment benefits Saturday when that emergency relief program expires. At the same time, the accelerated depreciation program that has allowed businesses to depreciate 50% to 100% of the cost of equipment purchases in the year of purchase rather than over 20 years, will expire.

Meanwhile, the additional market spike of the last year has stocks much closer to, if not already at, over-valuation levels. The average lifespan of the 11 bull markets since 1950 was 53 months. The current bull market is now 57 months old.

None of these observations, differing markedly through the windshield from what is seen in the rear view mirror, constitute sell signals. Nor can they predict when a market might top out.

But they do indicate the changed risk as we enter 2014, and how the ‘recency bias’ that has investors so enthralled now may become a problem.