These last few weeks have been quite interesting and have brought out some intriguing comments from the investor and analyst community alike. Yet, the underlying theme, as seen by this market observer, is that investors and analysts truly believe that they are being objective, when, in fact, they are simply being driven by their base biological drives without even realizing it.
Allow me to begin to explain what I mean by citing a study you have likely seen noted from me before.
In a paper entitled “Large Financial Crashes,” published in 1997 in Physica A, a publication of the European Physical Society, the authors, within their conclusions, present a nice summation for the overall herding phenomena within financial markets:
“Stock markets are fascinating structures with analogies to what is arguably the most complex dynamical system found in natural sciences, i.e., the human mind. Instead of the usual interpretation of the Efficient Market Hypothesis in which traders extract and incorporate consciously (by their action) all information contained in market prices, we propose that the market as a whole can exhibit an “emergent” behavior not shared by any of its constituents. In other words, we have in mind the process of the emergence of intelligent behavior at a macroscopic scale that individuals at the microscopic scales have no idea of. This process has been discussed in biology for instance in the animal populations such as ant colonies or in connection with the emergence of consciousness.”
Effectively, this supports my premise that most investors and analysts believe they are viewing markets objectively, yet, in reality, they are simply following the herd and coming up with reasons for doing so after the fact. Moreover, it is quite clear from the many studies conducted over the last 30 years, this is simply due to a natural emotional response for which they are hard wired.
I saw an interesting article this past week entitled: "The S&P 500 is inflated by 25% because investors won’t focus on the fundamentals." Let’s try to understand what this author was saying. The author is clearly under the impression that fundamentals are not driving this market. Therefore, something else is driving this market, and it is likely emotion, which causes investors to supposedly ignore fundamentals. But, the author is erroneously working under the assumption that fundamentals are what are supposed to drive the market.
What the author fails to understand is that emotion is driving the market all the time, and not just when he perceives the market is not following fundamentals. When the fundamentals align with the market, it is just coincidental. And, if you look at every major top and bottom in the market, you will not see any fundamentals supporting the move to those extremes, as they are always emotionally driven. Therefore, fundamental drivers are really coincidental drivers and not direct drivers of the market. Yet, he is unwilling to make that logical leap, as most people do not want to believe they are driven by their emotions. Most would rather believe that they are driven by their logic and reason.
If the market is an emotional environment at its core, can you really believe that reason or logic will assist you in identifying the major turning points? I have used this example many times in the past, and it is quite apropos to explain this point. When your spouse is emotional, how effective is it when you attempt to argue with them based upon logic and reason?
So, in the end, we must be honest with ourselves and recognize that it is really our emotion that makes subconscious decisions about the market, especially at the major turning points. Therefore, most will usually follow the herd and be uber-bullish at highs and uber-bearish at lows. This is a fact that any market historian or insightful investor understands, and with which the rest of us must come to grips.
As Daniel Crosby said in his book The Behaviorial Investor:
“Our flawed brain leads us to subjectively experience low levels of risk when risk is actually quite high, a concept that Howard Marks refers to as the “perversity of risk. While we tend to think of bear markets as risky, true risk actually builds up during periods of prosperity and simply materializes during bear markets. During good times, investors bid up risk assets, becoming less discerning and more willing to pay any price necessary to take the ride. Risks compound during such periods of bullishness, but this escalation goes largely undetected because everyone is making money and the dopamine is flowing. You likely grasp this intellectually, but your brain will do everything in its power to make sure that you don’t act accordingly.”
As he also stated:
“trusting in common myths is what makes you human. But learning not to is what will make you a successful investor.”
As I sit here writing this missive, I am contemplating the significant speculative excesses we are seeing in the markets today. Let me give you a couple of real-life examples.
This past weekend, I went away with my wife and attended a different synagogue than I normally attend on the Sabbath. One of the members of this synagogue was explaining to me how he has been recently telling everyone who will listen to buy bitcoin as it is going to rally so much higher. Now, when someone approaches me to tell me about his feelings regarding the market without even knowing me, well, I think this is speaking quite loudly about what now seems to be a ubiquitous view about Bitcoin and speculative excess.
But, please do not believe it only applies to the average person. This perspective extends to analysts as well.
Last week, I was honored to be a speaker and a panelist at the 50th Anniversary of the New Orleans Investment Conference. One of the themes I heard at the conference was that Bitcoin could be one of the products that takes the place of the US dollar, and that is why it rallies when the dollar drops. Well, I guess one has to live in their own bubble to buy into such a theory. Consider that the DXY has rallied from 103 to 108 during November while Bitcoin has rallied 47% during that time. But, I digress.
When I was sitting in the green room before going on stage for my first presentation, the topic of Bitcoin came up amongst the other speakers that were there as well. One of the older speakers sitting in the room was going on about how Bitcoin is now going to be unstoppable and has begun its move to $1 million. He then stated that one can easily buy it now even though it was trading just below 100k at the time.
So, I decided to open my mouth and explain that my analysts at Elliottwavetrader.net are expecting it to top out in the near term (as our long-term target has been 100-125k for quite some time), and we could easily see it drop by more than half from that resistance region, and spend the next few years in a bear market. Well, this other analyst then looked at me, chuckled, and then went back to what he was reading before he made his comment. Clearly, the perspective that Bitcoin could strike a top soon is laughable and not even a consideration.
Now, if you really do not believe that we are seeing speculative excesses today, consider that a banana duct-taped to a wall was just sold at auction at Sotheby’s for $6.2 million to a crypto-currency investor. In fact, this single banana was reportedly purchased on the day of the auction for $0.35 according to the New York Times, and then duct-taped to a blank wall.
The purchaser even explained his reasoning for purchasing this “artwork:”
"This is not just an artwork. It represents a cultural phenomenon that bridges the worlds of art, memes, and the cryptocurrency community. I believe this piece will inspire more thought and discussion in the future and will become a part of history."
Just to add to the narrative, Sotheby’s expected that it would sell between $1 million and $1.5 million. So, do you really believe this purchaser used his reason to buy this artwork, or did the emotion of the auction drive this enormously inflated price?
Folks, this is exactly how markets work. Markets will often extend well beyond reasonable expectations, with the investors buying into a narrative as to why such valuations are justified, even though the buying is being driven by emotion rather than reason.
As Franklin once noted:
“So convenient a thing it is to be a reasonable creature, since it enables one to find or to make a reason for everything one has a mind to do.”
So, at the end of the day, while you may believe you are buying and selling based upon your reason, you may want to reconsider that perspective and recognize just how much your decision-making is being driven by emotion. And, when you are able to rise above your emotions, then you move into an elite class of investors that will not be caught looking the wrong way at the major turns in the market.
I will conclude this missive with the wise words of Bernard Baruch, an exceptionally successful American financier and stock market speculator who lived from 1870– 1965:
“All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking our theories of economics leave much to be desired. It has always seemed to me that the periodic madness which afflicts mankind must reflect some deeply rooted trait in human nature — a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea It is a force wholly impalpable yet, knowledge of it is necessary to right judgments on passing events.”