Positive Feedback Loop & Market Trends

There is a psychological concept of a positive  feedback loop. For example in the situation of anxiety: something triggers us to be anxious about something, perhaps our child is missing in a crowded area.

We start to have a higher heart beat but because we become acutely aware of our anxious condition, we become even more anxious.

Similarly, for the stock market, when we see our stock prices dropping sharply in one day we feel anxious..something about the company is not right with investors. But if the next day, stock prices continue to fall further, our fears are confirmed and the anxiety turns into a panic: soon we ask if we should sell now before it gets worse: should we buy later when the market stabilises?

When we finally succumb to this fear and sell our investments along with the crowd, the market crashes as the panic spreads to all other investors.

A positive feedback loop can also occur with a rush to buy. When we see stock prices rising amid general optimism, there is a tendency to buy more as we are ready to make more money. So if the overall market rises, the perception of optimism is reinforced and we buy more. As a result, this causes a widespread bull market.

The takeaway here is that human emotions can be self-reinforcing: the positive feedback loop.

Currently, the two themes driving market sentiment are: on the one hand, the trade war and on the other hand, speculation that the Fed will cut rates by 50 bps this year.

Among professional investors, positive feedback loops can be very profitable. A hot theme could be driving the bull market eg Internet stocks, China stocks, emerging market stocks or cryptocurrencies.

Momentum investing is when we buy more stocks because 8 out of ten investors are buying and expecting more upside. It may have some fundamental basis, profits may be robust but valuations are no longer cheap.

In fact, even when valuations are expensive, investors are nonetheless, unwilling to sell simply because others are still buying, the bull is still strong or as they say, the market still has legs to run.

(our anxiety systems are very practical: they assume that any markets that falls is dangerous. The proof of that is, of course, the fact that the market falls).