We're Not Through Yet: Keep A Cool Head As Indicators Rise

In my previous column I made several suggestions for successfully navigating our times to a brighter future. The markets had been historically, mind-numbingly volatile all year, taking the gyrations to record proportions. Frustration with the status quo among investors was high and concern over volatile stock prices, developed country politics, and consumer and government debt levels dominated the media. What a difference a couple of months can make! When the numbers were tallied in early April, we had just finished the best first quarter since 1998.

We need to stay calm because we're not through yet.

True, the markets got off to a roaring start this year. Investors suddenly swung from nervous and uber-conservative to seeking return--and risk--in far-flung places and asset classes. Emerging markets rallied, while blue-chip, dividend-paying stocks languished. The outflow in stock mutual funds staunched somewhat as the indexes soared.

As reported by global consulting firm McKinsey & Company, CEOs noticed. In its March 2012 Economic Conditions Snapshot, McKinsey found that more than twice as many of the world's CEOs surveyed believe the economies are better now than six months ago--even in Europe--and an even larger share expect they'll be even better six months from now.

From watching this survey for years, I believe the trend is clear: Executive optimism or pessimism is more tied to stock-market behavior than economic reality. For example, when asked this question back in June 2007, only 13.2 percent of CEOs thought their countries' economies would be moderately to substantially worse in six months.

Yo-yo investing

This tendency to vacillate from fear to optimism and back again is an age-old issue in the stock market. Since anything denominated in numbers is precise, accurate, and measurable, we'd like to think participants' behavior and results will be much more rational and predictable, right? Our business schools still teach theories that hold markets are efficient and investors make decisions only after thoughtful analysis of risk and potential return.

However, as we've noted so many times in this column, markets and businesses and politics and all sorts of institutions are driven instead by humans, and we certainly have a tough time separating emotion from decision-making.

A chart we've used with clients over the years visualizes the yo-yo investing this tendency can produce if we let emotions run rampant, illustrating how the market's (or more accurately, the economy's) intrinsic value typically follows a steady upward path over the long haul while sentiment goes up and down like a yo-yo. We go from irrational exuberance to Chicken Little paranoia--overshooting and undershooting. From cautious optimism, up we go to excitement, thrill, and exuberance before plummeting down to anxiety, denial, fear, desperation, panic, capitulation, despondency, and depression. And back again. And again.

The cycle used to take years but occurred three or four times last year alone. Global strategist James Montier puts it best when he says, "Each of the spikes in volatility occurred when investors went from losing their minds at the top of the market to losing their nerve at the bottom."

Underlying problems remain

It's fascinating how investors will overlook and rationalize away even legitimate concerns during times of optimism and do the opposite during rocky periods when they willingly ignore obvious signs of real growth, turnaround, and opportunity.

Fortunately, when we recognize our yo-yo tendencies, we can circumvent this process in our individual lives through saner actions in our portfolios and 401(k)s. After all, we're the only creatures capable of putting a pause between a stimulus ("Stocks are going up, everybody but me is making a killing!") and our typical response ("Gotta buy!"). Personally, I suspect the current interlude may be one of those points in time where pausing is very important. Why? Because the fundamental, underlying problems remain.

Yes, better stock prices alleviated the immediacy of some of last year's fears, but a robust equity market doesn't change the fact that most developed countries are still overloaded with sovereign debt, unemployment is still painfully high, economic growth is still sluggish and lackluster, and politics are still contentious. People have just chosen to forget those woes for a bit and take an overly optimistic breather.

Did you notice that's even represented this spring by retailers trying to cash in on the mood? Bright colors are everywhere--neon pink, green apple, firecracker orange, "pool" blue, and lemon yellow--in everything from shoes to deck furniture!

Don't get me wrong. It's lovely to have put some psychological cushion and Dow points between the present and last year's debt-downgrade despondency. But the underlying issues remain, and there are no quick fixes. Only time and lots of hard work and political compromise can right our nation's ship and put us on solid footing again.

Meanwhile, let's not get so swept up in the relief that we forget Investing 101: what matters most is to know the true value of an asset you own or are thinking about owning, instead of getting caught up in "crowd-think." It's like not borrowing the max of what an underwriter would lend you on a personal property; a wiser course is trimming when the crowd is overvaluing and buying when they're undervaluing.

When we evaluate stocks, we look at the value of the entire company as if we were to buy it and take it private ourselves. So in these heady, up-market times, I say, "Keep your head. Be diligent, do your homework, pay attention to the underlying fundamentals, and don't try to keep up with the stock market Joneses." You will stay the course and prevail over the long term.

We're not through yet... and never really will be.

Carol M. Schleif, CFA, is a director in asset management at Abbot Downing, a Wells Fargo business that provides products and services through Wells Fargo Bank, N.A. and its affiliates and subsidiaries. She welcomes questions and comments at carol.schleif@abbotdowning.com.