Game Theory for Bulls & Bears

Bulls and Bears in Role Reversal
After large gains in the stock market, bulls and bears seems to have switched places — bulls are pessimistic, while bears act as if they have been vindicated.
Bloomberg, April 8, 2014

“Capitulation” is the term used to define a selling climax that often marks the bottom of a bear market. It translates into “surrender” — giving in to the overwhelming need to just make the pain stop. Retail brokers tell tales of individuals bailing out, often saying things like, “Just sell, get me out, please make it go away.”

We also can see capitulation at a market top, where bears throw in the towel, finally flipping bullish after missing out on too many gains.

Based on the recent market action — a mere 3 percent below a record high — bulls shouldn’t be capitulatory. We don’t see the usual indicators of a market top. Yet some of the commentary accompanying the retreat from these highs sounds more like an admission of defeat from the bulls than a victory lap. Listening to BubbleTV, reading commentary from respected bears, hearing the war cries of those who haven’t enjoyed the gains can be a bit confusing. The bulls seem sheepish and cowed, the bears emboldened and self-confident.

How can this be?

Perhaps game theory can help us explain this disconnect. The bulls don’t want to look stupid. Having been right for a number of years, they seemingly fear making optimistic pronunciations that get them tagged right at the top. The bears, meanwhile, having been wrong for this entire rally, have nothing to lose by doubling down on their past wrong predictions. If you have missed triple-digit gains, what does missing another 20 percent or 30 percent matter?

Five years into a rally in which markets are up more than 175 percent should cause both sides to reconsider. Some money managers are doing this already. As I noted yesterday, a rotation is underway. The wilder, hot names have been sold aggressively, and the old techs — Qualcomm Inc., Microsoft Corp., Intel Corp., Cisco Systems Inc., Oracle Corp. — are doing relatively well. The newer names — Tesla Motors Inc., Netflix Inc., Facebook Inc., Twitter Inc., LinkedIn Corp., SolarCity Corp. — have all been punished for their high price-earnings ratios and lack of dividends.

If you have been long during most of this bull market, you may want to consider rebalancing your portfolio to reflect the profits in the equities with the biggest gains. If your tech holdings have gotten shellacked, consider owning a mix of both the high fliers along with the more conservatively priced equities.

What if you missed the move up? Retail investors should reassess based on a few well-defined principles that I have described at length in the past.

I also really like this advice from Jeff Saut, the chief investment strategist at Raymond James, which manages more than $400 billion. He tells of a tactic from one of his favorite bears: After anticipating a major correction, this money manager found himself holding excess cash. Rather than trying to pick a single point to jump back in, his approach is mechanical. With each 3 percent gain in the Standard & Poor’s 500 Index, he invests 1 percent of his cash in stocks on the long side. If the market continues to rally, he gets slowly dragged back to the right side of the trend. If the market is near a top, he has only risked a small percentage of his cash.

Whether you are fully invested or all cash, you should have a plan that allows you to self-correct if the market proves your posture wrong.

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Originally: Bulls and Bears in Role Reversal