Wednesday, 12 November 2008

Climbing the Wall of Worry

"Wall of Worry" is a phrase used to describe a bullish market trend occurring in the face of negative uncertainties. Risks that have been realised in the market lead to investors thinking that things can only get better - it creates a buying opportunity that through prices rising leads to profit. However, once the risks are resolved, this destroys the wall of worry, causing prices to fall back to their natural level.

This tension between rising and falling prices is explored in more detail in the following model (click to enlarge).

The above Southbeach model shows the tension between rational and emotional behaviour in the investment markets along with their causes and effects. This is a complex situation involving multiple feedback loops that essentially creates a self sustaining system that oscillates between stability and instability as rationality and experience struggle to win out over greed, fear, and emotional behaviour.

Central to this model is a self-sustaining feedback loop of irrational investing resulting in volatility in the market that produces negative feedback causing further irrational, or short term, investing. In the centre of this triumvirate of effects is greed and fear, which perpetuate the situation by creating more emotional behaviour that creates even more volatility in the market, and destroying rational behaviour, which is insufficiently counteracting the negative feedback loop that is creating a "vortex of misery" in the market. This vortex of misery is characterised by the interplay between speculators that are in adulation at the profits they are making on their short sells and the rational investors with their more conventional practice of going long, who become excluded by those seeking to perpetuate the bubble. Eventually this vortex creates a tipping point (the point at which the bubble bursts). As this MarketWatch article explains, 'For those trying to take the pulse of the market, the size of the proverbial "wall of worry" can mean the difference between a correction and a change in trend'. As Charles Mackay, in his 'Memoirs of Extraordinary Popular Delusions and the Madness of Crowds' wrote almost 200 years ago, 'men go mad in crowds but come to their senses slowly, and one by one'; The change in trend is a tipping point in the market, which in this model creates a return to sanity that removes the speculators and emotional behaviour from the game, restoring rational behaviour and adding to experience that in turn hones instinct to return the market to a positive investing cycle based on an understanding of the emotional factors that led to the original volatility and downward spiral.

At the root of this repeating cycle in the market is a causal chain shown below. In this Southbeach model, the same chain of causes and effects is shown from two perspectives. In both cases, complacency leads to emotional distortion which leads to a market bubble that increases the emotional distortion further, increasing the size of the market bubble... and so on, until the tipping point is reached and the inevitable market collapse ensues. As the market is collapsing, this leads to realisations that further feed the collapse, finally once the market has returned to 'normal', complacency sets in once again and the cycle repeats. In the model on the left, the Speculators perspective, this market bubble is seen as a good thing as it creates an opportunity to create wealth through short selling, the market collapse being harmful to them both due to the stocks they purchased at inflated prices, and due to the lost ability to short-sell and make short term profits. The rational investor, on the other hand, has exactly the opposite perspective - the reality is the same; the causes and effects play out in exactly the same way, they simply see the bubble as harmful as it destabilises the market and the collapse as useful as it marks a return to normality.

This series of Southbeach models was created by Jason McIntosh, a sales trader at Nomura and Mark Burnett, a management consultant at BearingPoint.

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