Psyched Out

By Daniel Kadlec

Among all the things that drive stock prices, basic market psychology is the hardest to figure. Are you a bull or a bear? For many investors, the answer is based on little more than a gut-level premonition of where stocks are headed. Yet market psychology, or sentiment, can with little prodding shift so decisively to one side of the fear/greed spectrum that it dictates the course of stock prices for months or even years.

Years? No one frets about herd behavior when it's the bulls who have everyone brainwashed--as was the case last year. Who didn't enjoy that historic 86% jump in the NASDAQ? The gain overwhelmed economic fundamentals, though. Fueled by our faith in technology and the riches minted in previous years, mass psychology swung to the greed side, and stocks were viewed as a bargain at any price.

Now we're paying in flesh--the fear side. Amid unprecedented and treacherous trading volatility, the NASDAQ has fallen nearly 40% in the past six weeks and shredded the nest eggs of untold numbers of latecomers. That's why it's best to have both bulls and bears striking a balance--to keep stocks tethered to reality. Lose that equilibrium, and you get boom, bust, pain.

Other than market psychology--now as gloomy as it was bubbly--not much has changed. Sure, short-term interest rates are rising, and dot-bombs are exploding like a string of very expensive firecrackers. But that's been going on for a year. The real explanation is the sharp reversal in sentiment, which is reflected in hundreds, if not thousands, of stocks whose every decline goes a little lower and every bounce falls a little short of full recovery. People buying the dips are getting killed.

The negative psychology--the fear--is further evidenced by how investors react to news. Before the spring sell-off, even bad news was a reason to buy because such an announcement cleared away any reason to sell. Now stocks like Cisco and Hewlett-Packard are falling even on exceptional earnings reports. With the good news out, the new logic goes, there's nothing left to keep the stock up. Better sell. The scary thing is that there is no way to tell how long this irrational gloominess will rule. Investors should come to grips with the possibility that we have entered an old-fashioned bear market--one that lasts six to nine months before reaching bottom, is marked by frequent suckers' rallies that pull bargain hunters in too early, and fails to recover quickly off the bottom. Give me a crash anytime; the next day is a buying opportunity. A slow bloodletting demoralizes. It doesn't end until the dip buying stops, and by the time you realize that's happened, you've missed a huge rebound.

We may not come to that. When the Fed is about done raising rates, which could be soon, market psychology will improve. But the way the economy is growing, there's a good case for rate increases extending well into next year, and that's a bear-market recipe. In such a period, better turn off CNBC and quit reading the stock tables. Stay diversified. Keep contributing to your 401(k) plan. Dollar-cost-average into favorite blue chips and funds. In five years, you'll be happy you bought cheap. Investing is a long-term game. That's been easy to forget. But now it's impossible not to remember.

See time.com/personal for more on bear markets. E-mail Dan at [email protected] See him Tuesdays on CNNfn, 12:20 p.m. E.T.