All That Glitters / The Herd Is Back

In the wild it makes sense; but how about the stock exchange?

Certain animals exhibit clear herd behavior. In the wild, it makes sense. If you're just one of a group of zebras and you see they're starting to run in a certain direction, you'd better run with them, because chances are there's a lion a-lurking.

People exhibit herd behavior too. If a man on the street starts staring at the sky, he'll soon be joined by other people. Fill a streetside cafe with people and soon others will be standing on line. The Israeli car market attests to the same phenomenon: Note the popularity of the Subaru in the 1980s, the Mitsubishi Lancer in the 1990s and the Mazda 3 over the past 10 years.

horses - AP - June 27 2011

That makes sense too. If somebody's staring at the sky, there is probably something interesting to see there. If a cafe is bustling, chances are the food there is good. If everybody buys the same car, they probably checked in advance and found it to be the best buy. By joining the herd, a buyer on the sidelines can help himself to that mass logic and make a rational decision without investing any time or effort in checking the alternatives.

But the herd effect can be deleterious, and can be especially bad for slow responders.

Later this week, Israel's provident and mutual funds will publish their statistics for June. But it's already pretty clear that Israelis sold stocks and corporate bonds - tens of billions of shekels worth - withdrawing hundreds of millions of shekels a day from these funds .

Ostensibly, the logic is clear. After a period of gains and profits, the skies have clouded over. Investors fear financial meltdown in Europe, slowdown in the United States and unrest in the Middle East as September approaches, with the possible declaration of Palestinian independence.

In recent months markets around the world have been in retreat. Many have lost gains accrued from the start of the year. Israel's situation is particularly bad: The TA-100 index has lost 9.2% this year while the MSCI index of global stocks has gained 1%.

One could argue that the poor Israeli showing stems from the increased security risk. Yet against that, Israel has been delivering terrific macroeconomics: high present and expected economic growth, rising exports and dropping unemployment. In the past, strong economics always trumped vague security risks.

Memories of 2008

So what's going on? One possibility is that the Israeli herd is stampeding, with no logic aforethought. Israelis stampeded out of mutual funds investing in stocks. The mutual funds therefore had to sell holdings in stocks and corporate bonds, which then fell, and there you have the makings of a vicious cycle: redemptions, selloff and dropping share prices leading to more redemptions.

In the last week, by the way, the herd heading for the exit didn't do well. As Greece shuddered, Israeli stocks gained 2.3%. How annoying if you sold your mutual fund holdings the week before.

The herd behavior in June 2011 is reminiscent of the reaction in October 2008. As global markets wilted in the throes of the global economic crisis, hundreds of thousands of Israeli investors fled the markets, locking in their losses. In retrospect, they left just when the losses were bottoming out. If they'd stayed in, they'd have done beautifully as the markets boomed in 2009 - and they started returning as prices hit new peaks.

The situation now isn't as bad as in October 2008. The skies are cloudy but the uncertainty is nowhere near as great as then. Nobody thinks the global economy faces another meltdown. If anything, stocks look more attractive than any other alternative. The increase in interest rates reduces the attraction of bonds. Bloomberg statistics show that American stocks are at their cheapest level in 26 years.

How did Bloomberg reach that conclusion? The combination of dropping share prices and rising profitability. The result is that the average price-to-earnings ratio of the companies on the S&P-500 index is just 14.5, compared with an average of 20.5 during the last 20 years.

The herd has been fleeing before the losses get worse, and because makams and money-market funds are assuring 3.5% thanks to the climb of interest rates. They can live with that for a few months. But those are weak excuses. First of all, 3.5% may look good compared with the bottom-crawling interest rates of the last two years, but with inflation of nearly 4%, it's pretty poor - at best protecting the money's value.

Also, no matter who you are or where you are, you can't second-guess the market. Nobody can be assured of getting out at the peak and getting in at the nadir. That strategy, whether as a solo flyer or part of a pack, is a recipe for losses.