Interview: Robert Prechter on mass psychology in the financial markets

Robert Prechter is a financial market analyst. He is also the author of 14 books, including Conquer the Crash, a New York Times bestseller. He is credited with reintroducing and popularizing the Elliott Wave Principle. Prechter is currently the president and CEO of Elliott Wave International (www.elliottwave.com), a market forecasting firm.

IBT: What are your thoughts on the psyche of the American public right now?

Robert Prechter: I think the most accurate guide to the social psyche is the stock market. Despite ten years of weak prices, the Elliott wave model and major-trend measures of sentiment (low dividend yield, low mutual fund cash holdings, etc.) still indicate historically high levels of optimism.

Social mood is down from the record-setting optimism recorded in 2000 and 2006 to 2007, but it is still high. Political events reflect the same thing: in recent primary elections, middle-of-the-road candidates fared better than radical ones, indicating social complacency. Despite mild expressions of social concern such as the Tea Party movement, the mood of society remains elevated with respect to the major trend.

Most people think that society is worried, but it’s not. It only seems that way because people are using the greatest extreme in optimism in 300 years as a benchmark. Look back in history, and you’ll see times of serious pessimism. This isn’t one of them.

IBT: In the last 300 years, can you give some examples of pessimism in countries that were considered superpowers? Examples of “blood on the streets” and thus great buying opportunities?

Robert Prechter: Sure, here are some examples just in the past 80 years:

In 1932, the superpowers were in depression and the dividend yield on the Dow was 17 percent.

In 1942, the superpowers were fighting a World War, [so that was a pessimistic period].

In 1949, economists warned of a post-war depression and the P/E ratio in the U.S. reached an all-time low of 6.

In 1980, inflation was raging worldwide, Treasury-bill rates were at 16 percent and the [pessimistic] public ousted the U.S. president in a landslide. By 1982, the inflation-adjusted Dow (Dow/PPI) sold at the same price it did in 1950.

IBT: So what are the implications of this current optimism for the economy and financial markets?

Robert Prechter: Optimism is deadly for financial markets. The record-setting optimism recorded throughout the last decade provided the worst one-decade performance ever for the S&P. Since optimism is still strong, it means that the stock market is still a long way from a bottom. And since macroeconomic trends follow social-mood trends, the economy is nowhere near bottom, either.

IBT: How much of the market today is driven by crowd psychology?

Robert Prechter: A hundred percent of it, as always. This is true even when markets are calm. Fundamentals do not determine stock prices. The stock market fluctuates up to 20 times more [than corporate bonds] around so-called valuation anchors such as earnings, dividends, book value, and dividend yield. There is no fundamental basis on which to value stocks. The Elliott wave model defines the fractal form of social-mood change, and that is what drives stock prices.

IBT: What are some recent phenomena of “hysteria” in the market place?

Robert Prechter: Extreme sentiment has accompanied every market turn of the past five years. At the dollar’s low in 2009, there were only 3 percent bulls among futures traders according to a daily poll conducted by Trade-futures.com. At the time, everyone said the dollar was doomed.

It then soared 20 percent, and at the peak in the dollar in June 2010, there were only 2 percent bears. Then everyone said the euro was doomed. Then the dollar plummeted, and a few weeks ago the dollar was back down to 6 percent bulls.

Single-digit sentiment readings used to be very rare. Now they are commonplace. In May there were only 2 percent bears on gold. A couple of weeks ago, there were only 2 percent bears on Treasury bonds. The intensity of herding in the markets recently is quite a spectacle.

IBT: For the Greek sovereign debt crisis, how much of it was triggered by crowd psychology?

Robert Prechter: All of it. How else but by elevated mood can one explain why supposedly rational bankers, insurers and pension fund managers purchased and held the debt of Greece or subprime mortgages?

These creditors were literally out of their minds. Their rational faculties were in a coma. Sadly, governments are trying to buttress a lot of bad debt, which shifts the losses from the reckless gamblers who took the risks onto innocent taxpayers. But even this gambit will fail in the end.

IBT: How much of the crisis was caused by bond vigilantes piling on?

Robert Prechter: “Bond vigilantes” is another term for people who can recognize certain impossibilities, such as the endless spending and borrowing of a debtor. Those who can’t see it aren’t paying attention.

The real causes of the crisis are the impulsive issuers of debt and the creditors who bought the stuff, not the people who belatedly realized that these IOUs were unsustainable. When I wrote Conquer the Crash, I forecasted a collapse of all bad debt and even said Fannie Mae would become worthless. At the time Fannie Mae was [institutional investors'] favorite holding.

A lot of the [scenarios in Conquer the Crash] has come true, but there is much more to go. It is amazing that most people still think the IOUs they hold will be repaid. States and municipalities are broke, but investors are buying their debts with the same level of conviction that they bought tech stocks in 1999 and real estate in 2005, the Dow in 2007 and oil futures in 2008.

Wait until the bond vigilantes, who are asleep at the wheel on this one, finally wake up and start selling municipal bonds. We haven’t seen anything yet.

IBT: Ok, so the whole Greek debt crisis wasn't a “justified” reaction to facts like the budget deficit that was over 13 percent of GDP?

Robert Prechter: Under my socionomic theory, it was not Greece’s inability to pay that triggered the pessimism about Greek debt. It was pessimism about Greek debt that triggered Greece’s inability to pay.

Think about it. If optimism had continued to rise to infinity, creditors never would have stopped buying Greece’s IOUs, and the Greek government could have rolled over increasingly larger debts forever. But when the trend of social mood changed in 2007, it eventually brought on various crises.

In this case, a few creditors sobered up and realized that Greece couldn’t pay. So, sellers appeared and a crisis developed where before there wasn’t one. Changes in social mood regulate all these events.

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