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Greater Fool Theory, Cognitive Dissonance, & Financial Instability

Tyler Durden's picture




 

Via Scotiabank's Guy Haselmann,

To successfully trade financial markets, it is often helpful to know where you have been in order to know where you are going.  This is particularly true today now that the Fed has stopped expanding its balance sheet and plans to ‘patiently’ withdraw accommodation in the next few months.  Therefore, let’s briefly review the past few years to see where we are now in the hopes are seeing what is to come next.

Open-ended QE was a quasi-promise to maintain accommodation until “green-shoots” appeared to have the potential of growing into a lush oasis.  Such an aggressive central bank policy stance instigated investor risk-seeking behavior; thus collapsing risk premiums.

Investors knew that any economic shortfall would be met with either a continuation of (or even greater amounts of) colossal accommodation.  Consequently, investors perceived an ideal ‘win-win’ situation, and thus, recalibrated their risk/return assessments toward maximizing risk tolerance.   The capital structure flattened as yields plummeted and equities soared.  A race to outperform peers and benchmarks ensued.

As this unrelenting pattern persisted year after year, investors became mindful that too much fertilizer might have negative consequences for the long-run health of the green-shoots (i.e., polluting the soil).  In other words, investors knew that at some point in time, overly-aggressive accommodation could either lead to, or become the cause of financial instability. However, the Fed has continuously eased those concerns by reminding markets of its ability to use macro-prudential tools (whatever they are).

As prices have soared and credit spreads have collapsed, future potential returns have shrunk; thus escalating downside risks.  Nonetheless, risk positions have changed little.  Why is that?

It is partially due to the design of our financial system where PM’s typically have legal mandates to be near-fully invested, while personal investors are taught to stay fully invested and that it is a fool’s errand to try to ‘market time’. Paradigm shifts (like today) that lead to portfolio adjustments typically begin with sector rotation (today), expand to asset allocation changes, and ultimately culminate with a tactical ‘risk-off’ flight-to-safety move.

In addition, a ‘greater fool theory’ situation exists where risk-takers believe they:

1) have the knowledge to recognize the opportune time when to pare risk;

 

2) are able to identify the key catalysts that will derail the ‘upside’, and ;

 

3) will have sufficient market depth  and liquidity to exit exposures without much slippage.

However, since the Fed’s balance sheet has stopped rising and FOMC members are warning that official rates are likely to rise soon for the first time in nine years, isn’t maintaining a ‘risk-seeking’ predisposition imprudent behavior and ‘yesterday’s trade’?  Since the Fed’s policy pivot has shifted the upside/downside distribution of market risk to a materially worse risk vs. reward tradeoff, shouldn’t exposures be adjusted accordingly?

There are some factors based in behavioral psychology that may explain the slow response.  Last January, I wrote a note that discussed ‘cognitive dissonance’:  a psychological term and state that exists any time a person holds two conflicting beliefs, values, or emotional responses.  Recent (today’s) wild market volatility may be exposing the conflict between investment positions and shifting beliefs.

Since investors are both structurally and voluntarily positioned for equity market upside, they yearn to ‘hear’ a supporting story to eliminate their inherent conflict.  As the Fed attempts to lessen accommodation, FOMC messages emphasize ‘patience’, due to Fed fears of disrupting the financial market ‘apple cart’.   Such soothing words falsely pacify investors.  Some investors might even be lulled into believing that the Fed will be so patient as to not hike at all in 2015.  This interpretation and other shaky justifications are made to ease the discomfort brought about by the incongruous situation of investor cognitive dissonance.

John Hussman wrote an outstanding paper on January 12th entitled, “A Better Lesson Than This Time is Different”.   It can be found on the Hussman Funds website.  In it, he tried to identify and classify market return/risk profiles.  He characterizes current equity markets as over-valued, over-bought, and overly-bullish.  He attempts to find distinctions between over-valued markets that become more over-valued, and those that are vulnerable to a crash.  Hussman believes the breakdown of market internals combined with inadequate risk premiums have made the equity market vulnerable to abrupt and severe market losses.

In order to justify general equity market over-weights, either risk premiums needs to fall further, or the economy and financial markets need to have reached a level of ‘escape velocity’ powerful enough to push them forward, even in the face of Fed rate hikes.  I find such a ‘soft landing’ scenario improbable at best.

Market Comment

I am concerned that a sizable equity market correction looms. Treasuries would benefit from such, but believe they will continue to trade extraordinarily well nonetheless for several reasons:

1) strong USD and yield pick-up makes them attractive to foreigners;

 

2) Fed is hoarding them (own 45% of all 10yrs and longer);

 

3) Regulatory rules have increased demand from dealership community;

 

4) Pension rule changes incentivize LDI;

 

5) US fiscal deficit is shrinking, and;

 

6) Strengthening USD is disinflationary.

[Note: While I remain a bond bull (back end), tactically, I would turn longs into a flattener just prior to the Jan. FOMC meeting which I expect to be hawkish.]

“It is a happy faculty of the mind to slough that which conscience refuses to assimilate.” –William Faulkner

 

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Wed, 01/14/2015 - 09:12 | 5659359 Headbanger
Headbanger's picture

Translation:

What gets launched into orbit comes crashing back down in a fire ball!

Wed, 01/14/2015 - 09:17 | 5659369 Cognitive Dissonance
Cognitive Dissonance's picture

Cognitive Dissonance is always there lurking, ready to give you a swift kick to the head.

Wed, 01/14/2015 - 09:29 | 5659389 NoDebt
NoDebt's picture

But after it happens, it's so OBVIOUS.  Everyone knew it was going to happen, called it, traded on it for a tidy profit (after taking a big loss up front) and is a genius.

Wed, 01/14/2015 - 09:30 | 5659394 MalteseFalcon
MalteseFalcon's picture

Interest rates are not going up.

Wed, 01/14/2015 - 09:43 | 5659444 BLOTTO
BLOTTO's picture

Their are so many damaged minds/brainwashed people, that 99% of the masses are incapable of rational thought.

 

Wed, 01/14/2015 - 11:28 | 5659993 PrayingMantis
PrayingMantis's picture

 

 

... >>> "so many damaged minds/brainwashed people, that 99% of the masses are incapable of rational thought." ...

 

... these two sayings might give a clue ... :)

 

... "a fool and his money are soon parted" ~ Tusser

 

... "There's an old saying in Tennessee—I know it's in Texas, probably in Tennessee—that says, 'Fool me once, shame on...shame on you. Fool me — you can't get fooled again.'" ~ G.Dubya Bush

Wed, 01/14/2015 - 11:14 | 5659923 LawsofPhysics
LawsofPhysics's picture

perhaps, but the laws of physics and Nature really don't give a shit.

Chance favors the prepared, always has and always will.

 

Wed, 01/14/2015 - 09:14 | 5659365 cossack55
cossack55's picture

Hard to be wrong when one takes both sides of an argument

Wed, 01/14/2015 - 09:16 | 5659371 Bill of Rights
Bill of Rights's picture
Fukushima released 13,000,000,000 times more neutrons than initially estimated Human Health at RISK

http://enenews.com/fukushima-released-13000000000-times-neutrons-initial...

 

Neutrons are the worst of the worst...

Wed, 01/14/2015 - 09:30 | 5659393 cossack55
cossack55's picture

Not reported on CNBS, CNN or FAUX NEWS so does not exist.

Wed, 01/14/2015 - 09:39 | 5659422 serotonindumptruck
serotonindumptruck's picture

ZH and enenews.

Two of my most frequented websites.

Wed, 01/14/2015 - 10:43 | 5659755 RaceToTheBottom
RaceToTheBottom's picture

This is more valid reason to take over a country than WS profits

Wed, 01/14/2015 - 09:20 | 5659379 Vincent Vega
Vincent Vega's picture

"the Fed has stopped expanding it's balance sheet and plans to 'patiently' begin withdrawing accommodation in the next few months." Stopped reading right there...a faulty premise.

Wed, 01/14/2015 - 09:46 | 5659452 SmallerGovNow2
SmallerGovNow2's picture

As was this bullshit...

5) US fiscal deficit is shrinking, and;

Wed, 01/14/2015 - 09:21 | 5659381 q99x2
q99x2's picture

It's time to teach your goldfish how to fend for himself.

Wed, 01/14/2015 - 09:23 | 5659382 buzzsaw99
buzzsaw99's picture

There Will Be MOAR

Wed, 01/14/2015 - 09:28 | 5659385 craus
craus's picture

I'll say it again Obama will not let this market crash while he is POTUS.

Expect that the always hiring FED is watching.

Now if by chance the new POTUS has a brain, expect different things.

Wed, 01/14/2015 - 09:31 | 5659397 cossack55
cossack55's picture

Just out of curiosity, what is your example of a POTUS with a brain.

Wed, 01/14/2015 - 10:14 | 5659577 LooseLee
LooseLee's picture

JFK the only one in my lifetime....

Wed, 01/14/2015 - 09:59 | 5659522 craus
craus's picture

Bigger clowns on this board than you know who.

Wed, 01/14/2015 - 11:06 | 5659880 Bemused Observer
Bemused Observer's picture

Obama has no say in it, nor does the Fed. Look at how volatile the markets are, and this is WITH interventions. What do you think those markets would be doing if all hands were off?

It's taking them all they have just to get us HERE...they are pretty much out of ammo and are close to being swamped.

When the crash does happen, it's gonna be a doozy, of the bowel-loosening variety. I just want to hear their desperate babbling after the fact, see the sickly greenish hue on their faces when they realize it's over and they can do nothing about it.

Wed, 01/14/2015 - 09:28 | 5659386 Quinvarius
Quinvarius's picture

There was a time when I believed the Fed would keep propping stocks.  They have allowed every other market to implode.  I wouldn't buy stocks with Jim Cramer's money at this time.  If gold rises to a normal level somewhere around 5k to recap global savings in gold, the economy might eventually recover.  But a whole lot of ponzi is going to come undone with that. 

Wed, 01/14/2015 - 09:30 | 5659392 breadonwaters
breadonwaters's picture

 

Damn!  My dogs ran away this morning and i have a doctors appointment in 2 hours......

Wed, 01/14/2015 - 12:18 | 5660198 shovelhead
shovelhead's picture

Unlike women, dogs never forget where the food comes from.

They'll be home waiting for dinner.

Wed, 01/14/2015 - 09:31 | 5659398 taketheredpill
taketheredpill's picture

 

 

Fundamentals have kept a few people "out" of this market.  Which looks bad now, but at least they had a signal to get out.  Nobody else will.

 

Of course thats what I thought last year. And the year before, and....

 

 

Wed, 01/14/2015 - 09:35 | 5659405 Quinvarius
Quinvarius's picture

They have had a lot of signals to get out.  It is pretty clear that as soon as they passed the derivative bailout law, the bankers started a meltdown.  Of course, they think they can survive it.

Wed, 01/14/2015 - 09:39 | 5659404 TideFighter
TideFighter's picture

This is fight club. We do not expect a soft impact. Sorry, Billy Faulkner. It doesn't matter if you fall from a 300' building or a 1300' foot building, it's not the fall the kills you. We climbed above the survival height a long time ago.

Wed, 01/14/2015 - 09:38 | 5659410 richiebaby
richiebaby's picture

Steve LIESman is now attempting to explain that bad retail numbers are bad in a good way.

Wed, 01/14/2015 - 09:42 | 5659437 SmallerGovNow2
SmallerGovNow2's picture

Steve is a f'ing idiot.  Sad part is, lot of idiots listening to him...

Wed, 01/14/2015 - 10:01 | 5659526 James-Morrison
James-Morrison's picture

The crash won't occur until after next presidential election. Think what happened last transition -- TARP.

It's the new pattern for installing a new leader.

Wed, 01/14/2015 - 10:53 | 5659792 Temerity Trader
Temerity Trader's picture

Is there still more than a handful of human beings trading this market? It has got to be 90%+ machines, all pre-programmed with massively complex algorithms and fed by limitless Fed Bank money creation. When certain parameters are met, they ‘buy’, others tell them to ‘sell’. Billions of shares are traded in seconds and the markets move in wild swings.

The consumer is toast, limitless debt creation with no downside seemed possible, but wasn’t.  Extend loose credit to everyone, keep telling them to buy more cheap crap from China, push equities ever higher. Win-win, as the bankers all patted themselves on the backs. “You need four more HDTV’s and five more I-Phones”, “Last year’s SUV is no good anymore, we will loan you money for eight years, buy another!” “You need to buy a house, they only go up in price, great investments!”

The lies will never stop, but our “growth” years are clearly behind us. Strong headwinds in an economy driven 75% by rampant materialism.  Those “new jobs” were all low- and/or seasonal and people need EBT cards just to pay for food. Millions now rely on disability checks. The Fed created this mess out of desperation. Hang on for some real turbulence ahead.

Wed, 01/14/2015 - 11:42 | 5660060 Ewtman
Ewtman's picture

Fed is hoarding them (own 45% of all 10yrs and longer)

 

The Fed's ownership of long bonds will become problematic when yields begin to rise in the near future. The 10 YR, in particular, will be a huge drag on all those mortgage companies and financial institutions that are using them to hedge home loans. Above 4% and they become a liability not a hedge. Yields are nearing a corrective bottom and will soon start to skyrocket. (the 78.6% retracement level is at 17.50 on the 10 YR, a Fibonacci level worth keeping an eye on)

That  4% level is probably only several months away (5-8?) which means bond prices will start collapsing soon.

 

 


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