What explains unrational turns?
While I was fumbling through my computer trying to find a classic caricature of Chuck Norris, I
came across something, that I admit I had forgotten. It doesn't concern only financial markets but also how we humans behave. How emotions guide our development. It is a simple chart, which, however, reveals how our emotions go from one extreme to another. On their way, they go through the so long studied, worshiped and calculated with bizarre formulas equilibrium. Economical, financial different social systems' equilibrium exists. It is a fact. It's only that it takes just as long as to feel it, to enjoy it and then to consider that it will last forever. And because our mind wants to see equilibriums around us, it is trying its best to deceive us that people are rational, and therefore, we strive for balance. It's just like human behavior can be predicted with some logical formulas and whoever has a Japanese calculator (like a brand new CITIZEN), he will win more money on the markets. That, basically is the idea of the professors in most of the universities of economics. Of course, they prefer to enjoy their theory without ever tried it in practice. We all know why.
Yet the reason for the human behavior is not rational but emotional. Our emotions flip from one extreme to the other and thus shape our reality. Speaking of extremes, let's get back to the chart.
In February 2008 I published in several forums a forecast of one of the main indicators for the development of the American economy - Dow Jones Industrial Average. More interesting, however, is the reason that made me post my forecast. Just in those moment, sentiment indicators showed that over 85% of market participants believed that the market will continue to collapse. At the same time the media headlines were striking:
US cuts interest rates amid fears of global financial collapse - Financial Times
In general, any normal person who had trusted his professor in the university, would say that the situation is truly tragic and indexes will surely continue to fall. Surely, but no. That is exactly the extreme emotional state of the crowd, that warns of a coming reversal. Take a look at the chart.
Near bottoms, the psychology of the crowd has same features every time - almost 100% of people are pessimistic, the media headlines suggest that the Armageddon is just a day in front of us, and the idea that the markets could reverse looks pretty much as science fiction to everyone. And just then, the market turnes its direction. In other words, my "absurd" forecast turned out to be exactly correct.
Near the peaks, the same crowd that has went the other extreme - the crisis is over and it can not be repeated again, as economic indicators are as brand new, Japanese calculators work with full energy, nearly 100% of all people are optimistic and media which is pushing forward to a statement of the Minister of finance, who says that the crisis is forgotten. But you know what follows when the crowd reaches one of two extremes - in the next moment it flips and takes the opposite direction.
And as we observe these abstract chart with various lines and numbers on them, we explain what led to a decrease or increase the length of the lines, it is nice to remember something important. These lines actually represent the world's economical development. A long line down means that banks will not give you more loans, or that your private pension fund may disappear, or that your customers will disappear, that your business partners will start to cheat, you can have difficulties paying your mortgages, or that your wife will love you less. And nobody will be able to help you. Cause they will be in the same position.
Higher chart lines mean some good things with which we are used to. Optimism in the mass psychology takes much longer than pessimism. We all know how good we feel when we can use less efforts to live more comfortably.
I propose to be alert and worried that the chart lines will go lower. Unfortunately it is very likely
