Amid the best start of the year for the S&P 500 since 1987, Nic Colas of ConvergEx offers some deep thoughts on how behavioral finance concepts can help us understand the dichotomy between last year's derisking and this year's rerisking in terms of market participant psychology. Between delving into whether a short-sharp or long-slow colonoscopy is 'preferable' Nic reflects (antithetically) on 10 bullish perspectives for the current rally and how the human mind (which still makes up maybe 50% of cross-asset class trading if less in stocks) processes discomfort in very different ways. Critically, while it sounds counter-intuitive to him (and us), focusing on the pain of recent volatility is actually more conducive to investors' ability to get back on the horse especially when the acute pain is ended so abruptly (intervention).
Nicholas Colas, ConvergEx. Hurts So Good
The best start to the year for the S&P 500 since 1987 makes the pain of last year’s volatility feel just a bit more distant. But at the same time it sparks the question: just how much pain do individuals even remember? Fortunately, there is a growing body of psychological work on the topic, with some illuminating lessons. Long bouts of pain that end with little discomfort are far preferable to short sharp shocks. That sounds a lot like a Greek sovereign debt default – long anticipated and likely soon upon us. And hopefully well enough firewalled to prevent collateral damage.
Or consider that subjects who actually focus on a painful experience while it is happening are more willing to immediately undergo further pain than those who performed some distracting task. Which might go part of the way to explaining the market’s ability to bounce back from gut wrenching – and closely examined - volatility. None of this assures a positive outcome for the rest of the year, to be sure. But it does explain why investors can plow right back into a market that has been so tough for so long.
I enjoy assessing the capital markets through the lens of behavioral finance, but I have learned from reading scores of academic studies that you do not want to be a subject in any experiment related to the discipline. Ever. Here’s just two examples:
In a widely quoted experiment by Nobel Prize winner Daniel Kahneman (with others, published in 2003) over 600 subjects undergoing colonoscopies were given different versions of the same procedure. One set got essentially a short version, where the pain of the process peaked out near the end of the exam. The other group got a longer version, with the last few moments in relatively little discomfort. The second group reported much less pain when asked about the experience than the first.
In another experiment, researchers from the Leeds University Business School (Read and Loewenstein, published in 1999) took groups of subjects and paid them to place their hands in very cold water with the intent of inflicting moderate but prolonged pain. One set of subjects were given a distracting task, while the other group was told to focus on the discomfort of the moment. Immediately after the process, the group that had nothing to distract them was actually more willing to undergo the whole thing all over again. But a week later, the distracted group was the more amenable to repeating the experiment.
There are other works in the corpus of literature on the psychology of pain, but these two suffice to show that the human mind processes discomfort in unpredictable ways. The first shows that how experiences end is far more relevant to the memory of it than the pain involved at the time, even if the overall time spent in discomfort is greater. The second shows (according to the researchers, anyway) that the mind actually needs to focus on pain in order to get over it quickly. The ancient Buddhist advice about living in the moment turns out to be true even when the moment is painful.
I thought of these experiments in pain as I watched the U.S. equity tape yesterday, marveling at what has become the strongest opening gambit for a January since 1987. Not that there’s any shortage of bear arguments (more on that in a minute), but because it was actually easy to sketch out a healthy list of near term positives for U.S. stocks. In about 4 minutes I jotted this “Top 10” list:
1) U.S. financial stocks have bounced back nicely from year-end tax loss selling, making it look (for the moment, at least) like investor confidence has returned to this beleaguered sector.
2) After a flush of excess enthusiasm for Q4 2011 earnings in the middle of last year, analysts have reduced their expectations enough for companies to meet them as we go through earnings season.
3) A lack of deadly European headlines, such as a failed auction or +8% Italian bond rates.
4) No hard landing headlines from China.
5) A Euro that seems to be standing on all four feet, even if genus and species of the animal are as yet undetermined.
6) Reasonable valuations for U.S. stocks, at least against the much-mentioned $100/share for S&P 500 earnings. And frankly even if they are $80/share.
7) A gaggle of decent news from the U.S. labor markets and consumer confidence.
8) Oil prices that have not materially lifted above $100 despite a hot civil war in Syria and a ruthless cold war, replete with unabashed assassinations, between U.S./Israel and Iran.
9) The expectations for inbound money flows into U.S. equity mutual funds in January from new tax year 401(k) contributions.
10) A rally that actually started in early October, did a pretty textbook reverse head-and-shoulders in November and December, and broke out about a week ago.
But what about the pain of the last three years, and the very clear prospect for more pain ahead? It would be just as easy, after all, to sketch out the Top 10 reasons (or 20, or 30) about why this rally is doomed to failure. And while I don’t want to anthropomorphize equity markets entirely – most estimates of daily volumes have carbon-based life forms responsible for less than 50% of daily activity – the pain studies I noted above can help put the S&P 500’s rally into context. Two thoughts:
Kahneman’s colonoscopy is a tailor made, if coarse, analogy to the ongoing sovereign debt woes in Europe. Both are unpleasant, and both have gone on for a long time. But recall that how painful interludes end is critical to how patients, or investors, recall their experience. If Greece’s seemingly inevitable default in March (and potentially subsequent ones elsewhere) can move smoothly, then the end of this particular chapter may resemble the procedure that Kahneman’s subjects found less painful.
While it still sounds counterintuitive to me, focusing on the pain of recent volatility is actually more conducive to investors’ ability to get back on the proverbial investment horse. Granted, the money flows out of mutual funds last year shows that this phenomenon, if it is happening, is not centered on the retail investor. But asset allocators such as those that manage pension funds are just as human, and it is likely this camp that is pushing money into equities the last few months. And there is good reason for them to do so, with assumed rates of return for such funds still +7% and U.S. Treasuries yielding only 2%.
The bottom line is that pain, like beauty, is in the eye of the beholder. And the way that eye views a painful experience is a critical variable in how its associated memory records it. The markets have been to hell and back in the past 3 years. But if (and a big “If” it is) policymakers and politicians can create some better outcomes in the coming months, then investors’ memories may not only focus on the pain but actually shift more permanently to the positive.
We agree that behavioral finance does indeed have plenty to teach market participants but our earlier discussion of the ever-slowing volumes in equity trading make us wonder if we are merely culling the universe of participants to the highest pain-threshold-capable (read TBTF funded) or shortest-time-frame-capable (HFT obviously) with the rest of the US investing public is in the middle having their net worth whittled away by the swings.