The Behavioral Quirk Recent Choppiness Reveals

The pullback that began in September isn’t over yet, as Monday’s -1.3% drop added to the S&P 500’s rough patch.^[i] As with all short-term volatility, we think it is impossible to know when it will end. But we have already seen an age-old truth play out: When pundits call for the stock market to do X and it does Y, they pout. Yet when it complies, they don’t cheer, either. Understanding this behavioral quirk can help make headlines easier to navigate.

This is a regular occurrence in bull markets. If stocks rise as forecast, headlines will call them overvalued. If pundits say the market is overvalued and needs a pullback to let some froth out, they will inevitably treat an actual decline as a sign the bottom is about to fall out. This isn’t universal—there are always exceptions—but it happens often enough.

The latter is what we are seeing now. Over the summer, we saw oodles of articles observing that the S&P 500 hadn’t had a -5% pullback since last autumn and warning the market was too calm—ignoring the Delta variant, inflation, supply shortages and all the other ghost stories hogging headlines daily.^[ii] The implication was that some volatility would be healthy, bringing prices more in line with reality.

Now we have that volatility, and US stocks have broken that -5% threshold. To be precise, the S&P 500 is now down -5.2% in price terms since its September 2 high. So naturally headlines are proclaiming that the stock market is now rational and everything is fine, right? Well, not exactly. They are now warning this is only the tip of the iceberg and things will get worse as rising costs wreck corporate earnings, the Fed reduces its quantitative easing (QE) bond purchases, supply shortages power lasting inflation and hammer the global economy and Congress fails to provide fiscal stimulus. We have taken all of these issues on in detail at one time or another and won’t rehash them here, not least because it would be a 2,500-word detour. But suffice it to say we think all are either false fears (QE’s end, lack of fiscal stimulus), unlikely to have as large and prolonged an impact as headlines allege (supply shortages and cost pressures) or likely too widely known to deliver a negative shock even if they linger a while longer (inflation).

In our view, from a sentiment standpoint, the rationale behind pundits’ newfound negativity matters less than the spreading of said negativity—its proliferation shows sentiment has retreated quite a bit since springtime. If investors were universally optimistic or spilling into euphoria, then commentators’ universal take would be along the lines of, this is a buying opportunity! But when pundits are able to see both rising and falling stock markets as problematic, the cognitive dissonance is a classic hallmark of more universally skeptical sentiment. It is a stock market version of people’s tendency to fear a weakening dollar one month and a strengthening dollar the next—which, as it happens, we also saw in headlines today. The tendency suggests a bit of dug-in fear people can’t shake.

This can weigh on returns in the short term. As Ben Graham famously observed, stocks behave like voting machines in the near term, registering people’s feelings. But notwithstanding the short-term effects, we think the overall change in sentiment is bullish. Bull markets climb a wall of worry. When sentiment is quite warm, as it was earlier this year, and people have fewer worries, then there might not be much wall left for stocks to climb. When sentiment nosedives and fears abound, it builds a few more bricks into the wall. It resets expectations, lowering the bar results need to clear in order to deliver positive surprise. In our view, this points to the bull market lasting longer than it otherwise might have, although the counterfactual is of course unknowable.

This is why we often say that volatility is normal and healthy in bull markets. It helps keep expectations in check and prevents people from getting too far out over their skis, giving stocks more time and room to climb. The key to reaping that climb is simple, albeit difficult emotionally. Instead of reacting to headline fears, remember the time-honored maxim: Be fearful when others are greedy and greedy when others are fearful.