In this section, we analyze the behavior of investors from 19 October 1999–12 January 2001, to demonstrate the biases in the markets, using the Nasdaq 100 (NDX100) and the S&P500 volatility index (VIX). Figure
illustrates the movement of these two indices during the period of our analysis in three phases: euphoria, transition, and bear market.
The NASDAQ 100 Index from 19 October, 1999–12, January, 2001. (
Data Source Bloomberg)
The collective myopia observed during this phase was a logical consequence of individual investors’ irrational behavior where more importance is given to information that satisfies their desire for maximum profits.
During the accumulation phase (19 October, 1999–3 January, 2000), prices started to increase progressively, influencing the perception of market players, leading to widespread optimism. The NDX100 rocketed from 2,362 points to 3,790 points, an increase of 60.45 % in only 53 working days. Everything in the environment was functioning in favor of sustainable growth as evidenced by high liquidity, favorable forecasts for companies, and prospects for economic growth combined with limited t inflationary pressures. The increase observed during this phase was accentuated by investors ready to repurchase the shares they had sold at lower prices as soon as there was a market correction. No one wanted to or could afford to miss the market rise. Trading in the market became a social trend, a fashion, allowing individuals to show off their wealth, and prove their skills. Thereby they were easily induced into the leverage buildup cycle.
The period between 4 January 2000 and 10 March, 2000, was marked by technical corrections and lots of speculation but overconfident behavior reinforced the bullish trend. Throughout January 2000, the NDX100 oscillated between 3,790 and 3,446 points, a fairly reasonable difference of 344 points or 9 %, owing to investors’ profit-taking. Investors created mental accounts, closing profitable positions and leaving open losing ones. Their unrealized losses were only considered an accounting loss or “paper loss” as long as they were not forced to realize them, such as in the case of a margin call.
On February 2 2000, the Federal authorities increased the rates by 25 basis points (bps) instead of the expected 50 bps, thus reinforcing the positive bias. Markets soared and on March 10, the NDX100 reached 4,587 points, an increase of 33 % in only 28 days. Investors became even more overconfident and increased their investments through leveraging. In fact, decisions were biased by the information selected to fit their thoughts and justify their behavior, otherwise known as anchoring behavior. Investors ignored cautionary calls by analysts who foresaw possibilities of market deterioration because of their desire for rapid gains and fear of missing a market upturn. They continued to leverage their positions, consequently amplifying the difference between market prices and fundamental values.
During periods of euphoria, the sensitivity of market players to media is incredibly high; an example of this phenomenon is illustrated by the so-called “Media effect”. Trading rooms are often tuned into financial media channels, where traders listen to the opinions of analysts. While TV channels may not be the best source of information, it is the most accessible to the trading public. Price fluctuations accompanied by the recommendations of financial journalists, increase (or decrease) the number of stock market transactions exponentially. It is thus useful for professionals to study how media influences the general public in their decision making.
The Media effect takes place when investors follow market tidbits or snippets of information. This effect is especially pronounced in periods of market excitement during which the categories of investors are quite diverse, ranging from large fund managers and professional investors, to nonprofessional investors and retired individuals. The following is a non-exhaustive list of psychological mechanisms by which journalists, intentionally or unintentionally influence their audience:
Financial journalists identify with certain social groups and as such, they are more likely to influence those groups. For instance, by writing an optimistic article during a bullish phase, journalists influence their readers to increase their investments. Tvede (2002, pp. 191–192) explains this effect using a medical example test.
Imagine you are presented with the following medical outcomes:
The result of the test is that when people are presented with the first outcome, they choose an option; but, when presented with the second outcome, they fail to make a choice.
Journalists often ignore criticism that calls into question their previous analyses. They tend to wrongly interpret new information in order to confirm their opinions.
Between 13 March, 2000 and 7 April, 2000, economic indicators confirmed the build-up of an economic heating and the future deterioration of the financial environment. Investors began to fear the possibility of a 50 bps increase in the interest rates during an upcoming federal meeting on 21 March. As a wave of anxiety started to sweep investors, the NDX100 fell by an average of 3 % per day between 13 and 15 March. On 21 March, the federal authorities increased the interest rates by only 0.25 point, which somewhat calmed the market. As the outlook turned positive, the market recovered. Here, we can discern the hesitation of the investors prior to the market reversal. They have a selective perception, unconsciously interpreting information incorrectly to rationalize their strategies and a selective exposure, where they are open only to information which validates their outlook. Unconsciously, investors adopt the same attitudes of others they identify with. However, they overestimate the number of people sharing their opinion. Meanwhile, large fund managers began to pull out of the market.
The deterioration of the financial market originally forecast becomes a reality. Between 28 and 30 March, the NDX100 fell by 10 %. Both investors and the media attributed this decrease to a simple market correction owing to profit-taking. On 31 March, the market rocketed to 4,397 points. 17
On 3 April, the market tumbled again, this time by 7.6 %. On 4 April, it fell by 13 % and closed at 4,034 points. The market bounced back on 7 April, closing at 4,291, an increase of 4.9 %; investors breathed a sigh of relief as the volatile week ended positively. It was still unclear, however, whether the market correction was simply a technical correction. Nonetheless, large investors had already started liquidating their positions.
Transition phase—the crash
The process of financial disengagement started as signs of a reversal grew stronger, monetary conditions tightened and anxiety took over. This period can be compared to trying to listening to an opera. We are so carried away by the music that we are able to block out any disturbing noise. As time passes, however, when the ambient noise intensifies, we can no longer ignore it and continue to enjoy the opera. This increasing noise represents the financial disengagement of market professional. Investors realized that the correction observed in the stock market prices was not the same as the previous one. This correction was more serious and did not seem selective and brief as it affected all market sectors. On 10 April, the NDX100 fell 300 points and prices continued to decline drastically in the following 4 days prompting authorities to suspend quotes on several shares. The successive suspension of quotes, however, aggravated the situation even more, owing to the temporary illiquidity it created and the following behaviors were observed:
Crowd behavior: the panic sent a clear signal of the critical situation to other market players, influencing the rest of the investors who ended up changing their attitudes. In short, the panic was generalized with optimal dissemination of information and investor’s horizons align. Many investors habitually adopt strategies that take into account long-term equilibrium. From time to time, however, investors forgo these strategies when they lose confidence in the market and in its future. The lack of comprehension of external events provokes a panic more accurately described as an “avalanche effect”. Sensory- tonic theory: The pressure created metabolic reactions which reinforced the escalation of panic. Subjected to stress, investors started to liquidate their positions. Liquidation made market prices fall even more and increased the margins call even more.
The market continued to drop every minute without showing any signs of stopping; on 14 April, the NDX100 closed at 3,205 points, a decline of 1,086 points (23 %) in 5 days. The Bearish trend (17 April–31 May, 2000) that followed the crash was marked by erratic fluctuations. No consensus could be reached and market players were lost. The mood fluctuated between positive and negative depending on market news. As such, investors were unable to think clearly and stick to their decisions without first having to review and analyze their decisions several times, ruminating over and over again. Now, the only pertinent information was the negative yields of the prices. In addition, margin calls amplified daily volumes on the sell side and aggravated the bearish trend.
On 16 May, indicators continued to show signs of economic heating, prompting federal authorities to increase interest rates by 50 bps. As a result, the market tumbled by 600 points. Owing to this substantial fall, investors hesitated for several days before buying in the market again. On 30 May, the NDX100 climbed by 9.6 % to 3,414 points. During this period, market fear was reflected in the high implied volatility where the VIX Index fluctuated between 27 and 35 %. Investors questioned whether this volatility spike indicated a short-term correction or if it was the beginning of a more severe correction. In reality, investors were hoping for a technical rebound following news that inflation has not reached an alarming level and that the economy was going to witness a soft landing. That was followed by a consolidation phase between June and September 2000 where the NDX100 fluctuated between 3,477 and 4,099 points.
Uncertain investors remained on their guard and the market remained nervous until the process of elimination started at the end of September 2000. Any negative information, regardless of its importance and whether it concerned only one company, affected the whole sector. The progressive elimination of categories of investors continued with the margin calls. During this period, it was crucial to ensure that the decrease in the price per barrel of oil was definitive and to evaluate the consequences of the fall of the Euro, which created an uncertainty relative to the period of profit reporting. The period of pre-announcement of earnings or warnings was an excuse for everyone to liquidate their positions. The NDX100 lost 13 % in 20 days. Investors were obsessed with the slightest details and were questioning themselves whether they had run proper analyses and whether they had overlooked any important information. They ended up by developing symptoms of depression in the sense that they were often unsatisfied and preoccupied. On October 2, 2000, during the Federal Reserve board meeting, Chairman Alan Greenspan’s commentary was pessimistic, owing to the resurgence of inflation fed by the increase in the oil price. Simultaneously, the weakness of the Euro against the U.S. dollar affected multinational’s margins which led to a series of “profit warnings” on behalf of these multinationals.
Following these events, an inverse schema was rapidly established wherein the decrease in share prices, deterioration of the underlying mechanism and bias reinforced one another. The NDX100 was in a bearish pattern (2 October, 2000–12 January, 2001) and the consensus was mostly negative. Market participants waited for a republican candidate to be elected, hoping for a new flow of liquidity owing to substantial tax reduction. By November 8, the elections were still in progress and the market was overwhelmed by enormous uncertainty pushing the NDX100 down by 7 %. At the end, G.W. Bush was elected as U.S. President on December 13. By then, however, pessimism had already overtaken the market. Market players felt that only a decrease in interest rates by the Federal Reserve could save these companies and uplift market, but nothing happened. Therefore, the NDX100 declined by 5.8 % the next day, to 2,340, a decrease of 34 % in 63 days.
On 3 January, following another 50 bps drop in interest rates, investors were very pessimistic and overestimated the deterioration of the economy and the markets. They were influenced by information, including that which was irrelevant, a phenomenon also known as the “touchy-feely syndrome.” The NDX100 declined by 48 % and each market rally became a “bear trap”. Throughout the bear market, an increase was deemed convincing only if the advance was based on economic and financial fundamentals news which can only modify the underlying mechanism.