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The Cruel Psychology of the 1,000-Point Drop

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If you don't already read Jason Zweig's regular column in the Wall Street Journal, you should. He is one of the few financial journalists worth reading. His recent article on the psychology of the recent market drop is rational and instructive.

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Click here to read the article in it's entirety:

http://blogs.wsj.com/moneybeat/2015/08/24/the-cruel-psychology-of-the-1000-point-drop/

See below for a snippet:

Experiments have shown, for instance, that people believe cancer is riskier when they are told that it kills “1,286 out of 10,000 people” than when they hear that it kills “24.14 out of 100 people.” Hearing “1,286” immediately brings a large number of victims to mind, while “24.14” is simply a much smaller number.
To notice that the first number is less than 13%, while the second is more than 24%, you have to focus on the denominators of the fractions and do some quick division. But your emotions will likely hijack your brain long before you get to that point.
Ask almost any investor if the stock market is more volatile than it used to be, and you will hear a resounding “yes.” That’s because the Dow routinely moves up or down at least 100 points in a day—a round number that sounds large and important.
But, even after the recent spike in volatility, the market has fluctuated far less sharply in the last three years than has been typical in the past. And even after the market’s recent haircut, 100 points is only about a 0.6% change in the Dow.
A 1,000-point move, on the other hand, is a full 6.6% decline. But how significant is it, and what should you do about it?
Stocks are still not cheap. The best guide we have to the valuation of the stock market—the 10-year average “cyclically adjusted price/earnings ratio” or CAPE, popularized by Yale University economist Robert Shiller—says U.S. stocks are still above their historical average.
On Aug. 4, stocks were selling at a CAPE of 26.4 times, about 50% higher than their average since 1871 and about 10% higher than they’ve run in the past three decades.
At the depth of Monday’s drop, stocks were down to 23.6 times—far from a bargain based on past levels.
But investors who want absolute certainty will be utterly disappointed. To be realistic about the future, you have to recognize the limitations of the past.
Historical data might feel as unchanging as an exhibit in a museum, but the financial past is nonstationary. As St. Augustine pointed out more than 1,600 years ago, time is a continuum. Today’s returns will be in the market’s past results tomorrow, and the “long-term” return changes slightly almost every day as the latest increment or decrement of performance gets averaged into it.
So the belief that the long-term average for CAPE of roughly 16 times is the “right” value for the market is dubious, says Prof. Shiller. Because the past is forever in flux, determining the proper level of valuation “is so fuzzy,” he says. “It’s not a science.”
The lowest the CAPE ratio got during the financial crisis was 13.3, in March 2009—partly because the 10 years of data on which CAPE is based still included, at that time, the euphoric period of 1999 and 2000. That ratio of 13.3 was barely below the long-term average. So investors who waited for a definitive sign, in 2008 and 2009, that stocks had gotten to bargain levels never got one—and missed out on the ensuing bull market.
We all long for certainty, some kind of chime or singing telegram that would tell us exactly what to do. After all the drama of the past few days, stocks are a little cheaper than they were before. They could get a lot cheaper still before this is over.
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