As US and other equity markets continue to hit new highs, we see increasing examples of Cognitive Dissonance emerging, notably in the response to the US Election. Historically this can lead to a sudden switch in the ‘narrative’ which can induce sharp spikes in short term uncertainty.
As ‘Humble Students of the Markets’ we are aware that we are as much about Psychology as we are about Economics or Finance. Indeed, that is why we believe in the concepts of Behavioural Finance that are embedded in our process known as Market Thinking. We believe that markets are indeed efficient, but specifically in so far as that, at all times, the current price reflects the balance of beliefs among different groups of participants and that those beliefs in turn reflect different expectations about risk and return. The mistake would be (and frequently is) to confuse our own risk and return tolerances and expectations with some sort of equilibrium level that the market ‘should’ obey, which is why we stress that it is important to listen to what the market is telling us, rather than to expect the market to listen to what we tell it that it ‘should’ do.
We should always listen to the market rather than try and tell it what it ‘should’ do. Right now it is still telling us it wants to go up, but we are listening closely for a shift in that message.
While there are a myriad of market participants, we break it down into three broad groupings to help manage our understanding. These are 1) Short Term speculators or traders, many of whom use leverage or margin financing and are looking to maximise upside returns. 2) Medium Term Asset Allocators or risk managers, the majority of whom are looking to minimise their downside returns versus a benchmark and will thus often ‘rotate into areas they are underweight’ in order to minimise their career risk – even if it is at the expense of investor return. They are usually unleveraged, although will use instruments such as futures and options that are subject to periodic volatility and distortion by traders. We might generalise the emotions of these first two groups as Greed and Fear. 3) Long Term Investors, are a mixture of both emotions, mostly unleveraged and looking to minimise absolute downside risk, they are generally less benchmark aware and tend to buy on the dips rather than sell the rallies in bull markets while sitting out of bear markets.
Thus at any one time, the market price of an asset will reflect the balance of buyers and sellers from these broader groups and their opinions and commentary will vary accordingly, which is why we subtitle Market Thinking as ‘making sense of the narrative’, for it is by listening to the narrative and how it evolves that we can hope to anticipate a shift in the balance of the markets; a momentum trader is not suddenly going to be persuaded by the in-depth, fundamental based thoughts of a value investor, but they might be spooked by concerns over, say, a tightening up in margin finance and start to sell which in turn may trigger a rotation out of momentum style stocks by the risk averse Asset Allocator and should that produce sufficient (downward) momentum in that ‘style’ relative to others then in due course the long term investor might be persuaded to divert inflows towards a value style. At each stage, this process could halt, reverse or go in a different direction although mostly it starts with group 1, which is why we watch the people we call ‘noise traders’ so closely.
It is against this background therefore that we are observing a possible ‘break’ in the narrative and one of the signals for us is a rise in what is known as Cognitive Dissonance in the world of Psychology. In Behavioural Finance this is closely related to a concept known as Confirmation Bias Wikipedia has a description of this that is as good as any.
Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms or supports one’s prior beliefs or values. People display this bias when they select information that supports their views, ignoring contrary information, or when they interpret ambiguous evidence as supporting their existing position. The effect is strongest for desired outcomes, for emotionally charged issues, and for deeply entrenched beliefs. Confirmation bias cannot be eliminated entirely, but it can be managed, for example, by education and training in critical thinking skills.
The reason that we are talking about this now is that with the inauguration of Joe Biden last week we see a dramatic rise in Cognitive Dissonance or Confirmation Bias as to Policy and are alert to the possibility that this could spill over into markets, not least because Policy has been dominating a lot of market behaviours for the last 12 months and because we suspect that the short term trader element has grown especially large in the US over that period, particularly in the retail space. Right now, everyone with their Robinhood accounts trading Tesla or Bitcoin believes that they have a New Normal lifestyle of trading momentum from their laptop, but right back to the days of Jesse Livermore (Reminiscences of a Stock Operator) or most recently the 2015 bubble in China, the threat of changes to the emotional state of traders, whether through a sudden change in consensus opinion or from policies such as new taxes or controls on margin lending makes this type of market very fragile. The situation is certainly stretched, there is currently an estimated $850bn of margin finance out in the US and as the chart shows, the Put Call Ratio is close to the the lows of the Dot Com bubble. “Everyone” is buying calls rather than puts.
Chart 1: “Everyone” is buying Calls rather than Puts
Other indicators are also flashing red, but as chart guru Nick Glydon of Redburn points out, “Are we January 1999 crazy or December 1999 crazy? For example, the ‘most shorted’ basket of stocks maintained by Goldman Sachs is up 30% year to date and one particular stock, Gamestop, has already gone up more than Tesla did last year, as shown in Chart 2 and moreover was the third highest volume traded on Monday after Tesla itself and Apple. Not bad for a video game store with a market cap this time last year of only $250m. (now $bn). One large Short selling Hedge fund has already had to be bailed out and one has to wonder if this ‘victory’ for the small trader over the professional may trigger some action by the Fed?
Chart 2: Targeting Short Seller. Will Regulators bring this Game to a Stop?
The real risk then is likely to be regulatory. Experience suggests that it is when regulators tighten up on margin lending (here the recent China experience is probably most relevant) or alternatively stops a certain type of trade such as this targeting of short sellers, then the unwind can be dramatic. One other obvious area of concern is the latest fashion for Special Purpose Acquisition Companies or SPACs, which have raised billions on the promise of finding undervalued companies and effectively bringing them to market without an IPO. Except of course there is the difficulty in the ‘finding undervalued companies’ bit, meaning they tend to be justifying high multiples for unprofitable businesses as an ‘out’ for speculators.
The reality is that Post Trump, there is something of an ‘after the War’ sense around things. With the perceived ‘enemy’ gone, the overwhelmingly Democratic voting US Media have convinced themselves and others that everything is going to be marvelous from now on. Such is the desire for ‘the Blue Pill’ that the US Media establishment seem to be in glowing approval of everything done so far by Joe Biden – even if it is exactly what Trump already announced (and they criticised) or, more worryingly if it is simply to reverse something Trump did, for no other reason than the fact that he did it. This can of course work both ways; copying Trump’s common-sense approach to re-opening the economy points to economically sensible political expediency (as discussed last week) which is a good thing, but cancelling the Keystone Pipeline and rejoining the Paris Accord points to economically expensive political posturing, which is not good, at least from a markets and economic viewpoint. Energy Costs for US companies and households are going up even if it makes the Biden administration more acceptable to the Davos Crowd meeting (virtually) this week.
At some point soon, some reality will settle in with the leveraged retail day traders, as it already has with the more risk averse asset allocators such as what if the vaccine doesn’t ‘work’? More specifically, what if the government wants to tax unrealised capital gains? What if something happens to bitcoin? What if the Fed moves to limit, margin financing? All reasons for the music to stop.
There are broader economic issues that need looking at as well. Has fracking run out of steam, either naturally or through upcoming restrictive policy and thus is the US’s short lived dominance in oil (not gas) now in retreat? If we listen to the Oil markets they certainly appear to think so and along with moves to continue to sanction Venezuela and to re-enter Iraq, the prospect of higher oil prices now threatens already Corona-damaged economies. As the chart shows, oil price are up 36% over the last three months
Chart 3. Stocks are still going up, but Oil is going up at three times the rate
There is a market point here that shouldn’t be overlooked either, for while the S&P is continuing to hit new highs, commodities, a natural rival for the attentions of short term professional traders, are going up even faster. What if they switch markets?
To conclude. The end of the Trump era has brought on some hugely uncritical thinking of the new administration but investors need to focus on the actual detail as well as be aware that just as the Democrats now have less incentive to keep the economically destructive lockdowns, they also arguably also have less incentive than the Trump administration to keep the stock markets artificially high with leverage and day trading. Regulatory shock looks the biggest short term risk at the moment.