Computerized or algorithmic trading accounts for 60-75% of stock market volume meaning the remaining 25-40% represents decisions by individuals who are emotional, irrational, and plagued by biases of various sorts. The net effect is rapid and sizeable changes in investor sentiment, even when there is little change in basic economic variables. Here are two illustrations of this phenomenon.
First, Nobel Prize winner Robert Shiller developed a simple means of estimating the fair value of the stock market which is relatively stable consistent with the fact that underlying fundamentals do not change rapidly. Interestingly, actual stock market prices are about fifteen times more volatile than this measure! Why? Because investors are constantly flipping between positive and negative assessment of economic and market statistics.
This tendency is beautifully illustrated by the following graph which portrays the percentage of investors who state that they are bullish. It is generated by the American Association of Individual Investors which has conducted a weekly poll since 1987. The bottom chart displays the percent that are bullish while the top one represents the price of the S&P 500. There are three takeaways. First, note that the percentage of bullish investors oscillates between 20% and 70% which is a very wide range. Second, it is apparent that large swings in sentiment can occur over relatively short periods of time. Finally, comparing the two graphs suggests that investors are very bullish at market tops and bearish at or near bottoms. Of course, those are financially destructive states of mind!
The message is that many investors are oscillating between bullish and bearish sentiment and their swings in emotion unnecessarily move markets. You can win by making sure that you do not respond to them!
