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Is Pessimism Actually Good for the Market?

We are trained to believe that as investors we want to be in an environment of extreme market optimism. On the surface, this sounds reasonable. When people are optimistic, money flows into the market and stocks head higher. It seems like an ideal situation.

But is it really? The argument can be made that an overly cautious market can be more favorable, because it limits the downside potential of major moves.

This idea is being presented as “The Freudian Put” by Phil Pearlman, the executive editor of StockTwits. In a recent interview, he explained his concept of The Freudian Put, and discusses why it can be a good thing for investors.

His thought is that over the last 10 to 15 years the market has been riddled with bad news, and he is right. The dot-com bubble, Iraq War, housing and auto crisis, debt ceiling… the list goes on and on. We have basically been conditioned to expect bad news.

Now you will ask yourself, how is this good for investors?

The idea is that we are so conditioned to bad news, that when it happens people overreact much quicker. On a day with bad news, the headlines are flooded with doomsday reports about the upcoming crash, or how it is time to jump out of the market and wait on the sidelines.

As any experienced investor knows, these are the sorts of the headlines that you typically see at the end of a sell off, not at the beginning. When everyone is talking about running for the hills, the smart money steps in and looks for bargains.

In the past, it would take weeks of selling for this sort of mentality to come out, but not in today's world. The doomsday headlines start to appear immediately. As a result, we see much quicker moves to the downside, and much quicker support being reached.

The overly pessimistic view is actually providing downside protection to major negative news developments. Pearlman believes that this has started to occur because of so many negative events in recent years, and while I agree with this, there are other reasons as well.

The internet is a major reason why this is taking place. Consider just fifteen years ago, when the internet was not nearly as widespread as it is now. The majority of Americans still got most of their news from actual newspapers, or the nightly news.

Times have changed. All the major newspapers have websites, where you can get daily updates on the market.  In addition, there are services like Twitter and StockTwits where news is being sent out non-stop for us to read.

Television news has also changed. No longer do we get our daily news while sitting around the dinner table watching the 6:00 o'clock news. News is on 24 hours a day, seven days a week. It is non-stop, and news broadcasters know what people want to watch. You can run a story on how great everything is, and people will tune out… however, if you run a story about how the whole market is going to crash and burn people will watch with great interest, and hence the headlines get more gloomy.

Pearlman's point is that as investors, we need to be aware of what is going on. We need to resist the temptation to over react to negative news headlines, and avoid acting too quickly. It takes patience and experience to become a successful investor, and in today's world it is important to remain focused on the bigger picture, and not let the flood of negative news headlines over individual events force us into quick decisions that we will regret.

You can watch Pearlman's interview video here.

Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.