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OTHERS OF NOTE
THE DELUSIONAL HIGH
When Reality, Misguided Perceptions & Delusion Intersect
EXPECT MONETARY MALPRACTICE TO LEAD TO DELUSIONAL BEHAVIOR
We wrote extensively in 2012 and 2013 how Monetary Malpractice was creating Moral Hazard and Unintended Consequences through Misinformation and Manipulation. In turn this was leading to behavior which involved increasing levels of Malfeasance, Mispricing and Malinvestment which was creating Dysfunctional Markets.
Deceptions of all types, if sustained over longer periods of time, usually lead to Distortions which in turn lead to Delusional expectations.
WHEN REALITY, MISGUIDED PERCEPTIONS & DELUSION INTERSECT
John Hussman recently observed in his Weekly Market Comment
Market extremes generally share a common formula.
- One part Reality is blended with
- One part Misguided Perception (typically extrapolating recent trends as if they are driven by some reliable and permanent mechanism), and often
- One part Pure Delusion (typically in the form of a colorful hallucination with elves, gnomes and dancing mushrooms all singing in harmony that reliable valuation measures no longer matter).
This time is not different.
THE FIRST DELUSION: THE TECH BUBBLE
REALITY: The technology bubble was grounded in legitimate realities including:
- The emergence of the internet,
- A Great Moderation of stable GDP growth,
- Contained inflation.
MISGUIDED PERCEPTION: But it also created
- A Misperception that it was possible for an industry to achieve profits while having zero barriers to entry at the same time,
- A Misperception that technology earnings would grow exponentially and were not cyclical.
- The Pure Delusion that historically reliable valuation measures were no longer informative.
THE SECOND DELUSION: THE HOUSING BUBBLE
REALITY: The housing bubble was grounded in legitimate realities including:
- A boom in residential housing construction,
- A legitimate economic recovery that followed the 2000-2002 bear market
- A Misperception that mortgage-backed securities were safe because housing prices had never experienced a major collapse.
- The Pure Delusion that housing was a sound investment at any price.
- The same Pure Delusion spread to the equity markets, helped by Fed-induced yield-seeking speculation by investors who were starved for safe return.
THE THIRD DELUSION: THE FED'S OMNIPOTENCE
REALITY: The present market environment is grounded in the legitimate reality that:
- The labor market has recovered its losses, but not to the extent that creates resource constraints or clear interest rate pressures.
- Though broad measures of economic activity have actually eased to year-over-year levels slightly below those that have historically distinguished expansions from recessions, the economy seems to be treading water, and don’t observe a particularly negative tone.
- The Misperception that monetary easing itself will support financial markets regardless of their valuation. The error here is that we know from history that it does not. Indeed, the 2000-2002 and 2007-2009 collapses both progressed in an environment of aggressive and sustained monetary easing. What’s actually true about monetary policy is that zero-interest rate policy has created a perception that investors have no alternative but to “reach for yield” in riskier assets. It’s entirely that reach for yield that investors must rely on continuing indefinitely, because there’s no mechanistic cause-effect relationship between the Fed balance sheet and stock prices, bank lending, or economic activity.
- The Pure Delusion is that this Fed-induced reach for yield is enough to make equities a sound investment at any price. Ironically, the Fed itself is in the process of reversing course on this policy.
As Michael Batnick also observed:
“Bull market tops are more difficult to call than bear market bottoms because doubt is a far more resilient emotion than hope.”
The dominant emotion at bottoms is fear — a palpable and very recognizable state. Tops on the other hand, come about through the combination of greed, complacency and indifference.
This is a much more challenging set of factors to identify.
- Indifference does not cause a huge spike in VIX, a standard measure of market volatility;
- Volume does not increase as traders become complacent.
As Barry Ritholtz writes, there are many other forces at play:
Risk aversion: This plays a large part in the differences between tops and bottoms. After a market drops 25 percent or more, the recency effect weighs heavily on investors. We dread losses at about twice the rate that we desire gains. That asymmetry leads to a variety of investing behaviors.
Because of this, we feel the losses of the big 2008-09 crash more intensely than we feel the gains of the 2009-2014 rally.
Biased perspective: Anyone with an investment in the market has a bias. It isn't a good or a bad thing; it simply is the way you are wired. Most investors who are long equities expect the market to go higher. Those who are out of equities, or (heaven forbid, short) believe that stocks will go lower. Hence, these market calls often reflect investors talking their book. I was reminded yesterday of an old joke about bubbles, as Art Hogan noted: “An asset bubble is an asset that is rising, that you have not invested in.”
Not rigorous: Most of the calls for a market top in this cycle haven't been very rigorous. Lots of gut feelings, sensations, and instincts, which history teaches us are a surefire way to lose money in markets. Contrast that with the analysis that Paul Desmond employs, using quantifiable metrics. That is a very different approach than merely guessing.
Fear is more visible than greed: During crashes, lots of metrics light up. I can give you a list of technical and sentiment measures that all pin the needle during a crash. On the other hand, the view from tops is much more nuanced.
No downside for pundits: Making a big splashy forecast almost guarantees calls from news media producers and naïve reporters. If by some stroke of luck, a talking head gets it right, it makes his career. On the other hand, few remember that wildly wrong money-losing call made on TV. Quick, name the person who said five years ago that hyperinflation would be the result of QE. Who noted a 1987 like crash was imminent every year over the past four years? Which pundit forecast gold at $5,000 an ounce?1
You don’t remember those calls because an endless stream of bad forecasts crosses your desk every day.
The future is unknown: The world is a complex place. Most people really don't understand what has already happened. We have a loose understanding of recent events, but we are far less informed than we believe. Discerning what is going to happen is an almost impossible task.
The bottom line is that these market calls are at best one part art, one part science. Whatever market calls people choose to make (or follow) it helps to understand this: No one is infallible, most are pretty bad, few are consistent. Luck plays a huge part as well. Even those who occasionally get it right are no more likely to continue that streak than anyone else.
I have no idea when this market will reach a top; it could have been yesterday for all I know. But I can tell you that if your investing process is highly dependent on correctly identifying when a market is about to top and reverse, I expect you will need new investment plan eventually.
"Investment is a game that you win by being approximately right. Precision is of secondary importance."
David Merkel in The Fundamentals of Market Tops writes:
Item 1: The Investor Base Becomes Momentum-Driven
Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
You’ll know a market top is probably coming when:
a) The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.
b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.
c) Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he "didn’t get tech," he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.
d) The recent past performance of growth managers tends to beat that of value managers. In short, the future prospects of firms become the dominant means of setting market prices.
e) Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.
f) Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.
g) Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.
Item 2: Corporate Behavior
Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.
Here are ways that corporate behaviors change near a market top:
a) The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.
b) Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
c) Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.
d) There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.
e) Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.
f) Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.
g) Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.
In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.
These two factors are more macro than the investor base or corporate behavior but are just as important.
Near a top, the following tends to happen:
1. Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.
2. The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed’s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.
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