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Why Investors Embrace Stocks When They Are Over-Valued

How consuming differs from investing, and why it matters to your portfolio

by Bob Stokes
Updated: November 21, 2016

When you find the item you want in a store, you hope the price is a bargain. Merchants, on the other hand, hope to charge the most you'll be willing to pay. When those hopes intersect, the sale is made.

If your favorite shirts are on sale for half-price, you may buy more than one. But if the price is 50% above what you expected to pay, you'll look for another brand of shirts. That's how consumers make decisions.

But that's not how it works in financial markets.

When stocks are "on sale," investors shun them. But when stock prices rise, investors embrace them -- in fact, the higher prices go the greater the demand.

This is why the supply and demand model we all learned in Economics 101 does not work in financial markets.

Consider this insight from a classic Elliott Wave Theorist:

The law of supply and demand is irrelevant to financial markets. There are no producers and consumers in financial markets, just investors. So there are no balancing forces on price. The law of supply and demand reigns at the shopping mall because consumers are pretty certain of their needs and resources, so they can reason their way through the decision process. But investors are uncertain because they have no basis for deciding a fair price. In the financial context, knowing what you think is not enough; you have to try to guess what everyone else will think. … When everyone faces this dilemma, the result is herding.

Yes, individual investors herd, but so do corporate investors, economists, futures traders, mutual fund managers, financial advisors and the list goes on.

Here's a chart and commentary from the May 2016 Theorist:

Financial advisors are almost always herding even when they advise against it. One of the commonest actions of herders is to deny a new trend in its early stages. At such times, seemingly sensible, cautionary advice not to “chase the rally” but to “sell the pop,” or not to “join the panic” but to “buy the dip,” reveals a misunderstanding of the intricate phenomenon of herding while simultaneously offering an example of it.

Behavioral economists are another group who routinely warn against herding but sometimes wind up joining the herd without realizing it.

Indeed, the chart below shows that the herding impulse is alive and well with economists as a whole:

The Wave Principle reflects this "law of patterned herding," and, right now, our analysis shows that an epic-pattern shift is just around the corner. Now is the time to prepare.

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