January 5, 2015
Pills for Cognitive Dissonance in a Speculative Bubble
In the 1950’s, Stanford psychologist Leon Festinger developed the theory of cognitive dissonance, describing the psychological conflict that results from holding two opposing beliefs or attitudes at the same time. When subjects were asked to convey or act on information that they knew was untrue (and were provided only weak justification for doing so), the resulting “cognitive dissonance” actually led them to change their own beliefs and attitudes to be consistent with the untrue information. It is difficult to hold opposing beliefs simultaneously. Festinger later showed that people typically respond in two ways to cognitive dissonance. Either they try to preserve their current understanding of the world by rejecting or ignoring conflicting information, or they abandon their existing beliefs to reduce the conflict.
Several years of persistent yield-seeking speculation provoked by zero-interest rate monetary policies have created a fertile ground for cognitive dissonance. On one hand, any observer with historical perspective knows not only that the overvaluation from this kind of speculation inevitably ends in tears, but also that the heavy issuance of new speculative and low-quality securities during the bubble finances and enables unproductive malinvestment that leaves the economy far worse off in the end. We should recognize that this same narrative was observed in the late-1920’s bubble-crash, in the tech bubble-crash, in the housing bubble-crash, and will be remembered painfully, but in hindsight, as the QE bubble-crash. On the other hand, prices have been advancing.
It’s difficult to entertain both of those facts at once. One must simultaneously hold in mind reckless yield-seeking speculation, hypervaluation that rivals the 1929 and 2000 equity market peaks (see Yes, This is an Equity Bubble), zero interest rates, low prospective long-term returns all around, and persistent malinvestment that poses increasing systemic risks for the entire global economy, plus one fact that encourages us to forget it all: prices have been going up. Cognitive dissonance tempts us to reconcile this tension by ignoring one part of the story or another.
For bulls, this cognitive dissonance creates the temptation to ignore the speculative risk and to dispense with valuation concerns by citing measures that have weak or zero historical relationship with actual subsequent market returns. The result is a stream of justifications for why stocks are reasonably priced and likely to advance without interruption. For bears, this cognitive dissonance creates the temptation to ignore the rising prices – to plant the valuation flag, knowing that a century of evidence on reliable valuation measures supports the strong conviction that market returns over the coming decade will be dismal (most likely negative over horizons of 8 years or less), and that the likelihood of a market loss on the order of 40%, 50% or even 60% in the next few years is quite high.
While we’re generally assumed to be in the second camp, I’ve done my best over the past year – particularly since June – to articulate our actual response to this cognitive dissonance. See in particular Formula for Market Extremes, Air Pockets, Free Falls, and Crashes, A Most Important Distinction, Hard-Won Lessons and the Bird in the Hand and The Line Between Rational Speculation and Market Collapse.
The best way to characterize our response is that it treats valuation extremes in a conditional way, which allows us to reconcile the full historical record without discarding inconvenient information. As I noted last week, what this framework requires, primarily, is the ability to withstand the cognitive dissonance of markets that are outrageously overvalued or undervalued, but persist until subtle deterioration or improvement in observable market internals and credit spreads indicates a shift in investor risk-preferences. When one faces two truths that are seemingly in opposition, the proper response is not to discard one of those truths, but to find a unifying principle that allows one to accept both truths at once.
We need not discard reliable indications that stocks are recklessly overvalued in order to recognize that there are certain conditions that allow a recklessly overvalued market to move higher still. Those conditions have been in place during much of the past few years, are not in place at present (see Iceberg at the Starboard Bow for a chart of cumulative S&P 500 returns in market conditions that match the present), but are subject to re-emerging, which for us could support a more constructive investment outlook even at valuations that are now well beyond twice the historical norm on reliable measures. There’s little chance that we’ll be considered bulls anytime soon, but there is a range of investment outlooks between hard-negative and constructive with a safety net.
In short, the near-term outcome of speculative, overvalued markets is conditional on investor preferences toward risk-seeking or risk-aversion, and those preferences can be largely inferred from observable market internals and credit spreads. The difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes, has little to do with the level of valuation and everything to do with investor risk preferences. Yet long-term investment outcomes remain chiefly defined by those valuations. That, right there, is the primary lesson of our own challenging experience in recent years.
This distinction was embedded into our pre-2009 methods, but was not sufficiently captured by the ensemble methods that emerged from my ill-timed 2009 insistence on stress testing our approach against Depression-era data. We ultimately reintroduced this distinction as an overlay to those ensemble methods. We completed that terribly difficult transition from our pre-2009 methods to our present methods of classifying market return/risk profiles in June.
The impact of these adaptations may take longer to become fully apparent. In recent months, market internals and credit spreads have been deteriorating while the major indices have clawed higher, so strategies that are long a diversified portfolio of stocks and hedged with cap-weighted indices haven’t had traction. But that phenomenon is consistent with a peaking process, as the hallmark of market peaks is a subtle internal deterioration that often precedes more obvious market losses.
I can’t offer any assurance about the near-term direction of the market or even the near-term effectiveness of our own strategy. I can’t assure that market internals and credit spreads won’t improve in a way that defers our concerns about steep market losses. The one assurance that I can provide is that we’ve addressed the challenges we’ve faced since 2009 in a way that is robust to data from every market cycle we’ve observed over a century of history. Maybe future cycles will be different, but I would much rather adhere to a historically-informed, factually coherent discipline that would have effectively navigated Depression-era data, post-war data, bubble-era data – and even the period since 2009 – than to assume that the lessons of history are useless or that inconvenient facts should be discarded. If you’ve followed my work for a long time, it should be clear that the framework I’ve described provides a consistent explanation for both my greatest successes and my periodic failures.
Though I certainly believe that we’re better equipped to navigate future bubbles (and even the present one if it continues), the fact is that my defensive views have been vindicated over time, even without these adaptations – and our pre-2009 experience bears this out. Recall that the 2000-2002 collapse wiped out the entire total return of the S&P 500 in excess of Treasury bill returns, all the way back to May 1996. The 2007-2009 collapse wiped out the entire total return of the S&P 500 in excess of Treasury bill returns, all the way back to June 1995. If the S&P 500 was to experience nothing but a run-of-the-mill 34% bear market decline over the coming 3 years, it will have underperformed Treasury bills for what would at that point be an 18-year period since 1999. On the most reliable metrics, current valuations aren’t much different than they were then, so payback will be, well... None of that excuses the challenges we’ve had in the recent half-cycle. Again, a stronger emphasis on investor risk preferences – as inferred from market internals – should make an easier job of navigating future bubbles (or even a continuation of the present one). But don’t believe for a second that the market gains of recent years will actually be retained by investors in any event.
Red Pill, Blue Pill
Probably the most interesting response to the cognitive dissonance provoked by the present yield-seeking mania comes from Hugh Hendry at Eclectica (h/t ZeroHedge) who quite clearly recognizes the repulsive long-term situation, but has embraced central-bank induced speculation out of the necessity of self-preservation as a money manager. I would actually agree with him here were it not for the fact that the behavior of market internals and credit spreads doesn’t really recommend an outlook tied to the world of illusion. That may change, and if it does, it would admit a greater range of investment outlooks in the category of “constructive with a safety net.” Hendry’s own struggle with the cognitive dissonance of this period is evident:
“There are times when an investor has no choice but to behave as though he believes in things that don’t necessarily exist. For us, that means being willing to be long risk assets in the full knowledge of two things: that those assets may have no qualitative support; and second, that this is all going to end painfully. The good news is that mankind clearly has the ability to suspend rational judgment long and often.
“Remember the film The Matrix? Morpheus offered Neo the choice of two pills – blue, to forget about the Matrix and continue to live in the world of illusion, or red, to live in the painful world of reality… I have long thought of myself as one of the enlightened. My much thumbed copy of Kindelberger’s Manias, Panics and Crashes aided and abetted my thinking as I correctly anticipated and monetised profits from the crisis of 2008 for example. But it isn’t always good. Kindelberger has been absolutely detrimental to my investment performance for the last six years and as a result I have changed. I still believe that the attempt by central bankers to prevent the private sector from deleveraging via a non-stop parade of asset price bubbles will end in tears. But I no longer think that anyone can say when.
“The economic truth of today no longer offers me much solace; I am taking the blue pills now. In the long run we will come to rue the central bank actions of today. But today there is no serious stimulus programme that our Disney markets will not consider to be successful. Markets can be no more long term than politics and we have no recourse but to put up with the environment that gives us; the modern market is effectively Keynesian with an Austrian tail.”
Pater Tenebrarum offers a thoughtful (and respectful) counterpoint:
“It seems possible that there is a catch. If no-one can say when, then the ‘blue pill’ strategy has a major weakness. It means that things could just as easily go haywire next week as next year. It should be noted that the focus of Austrian business cycle theory is really on the boom, its chief causes and effects, and the fact that instead of increasing prosperity, it will lead to impoverishment in the long run. The major difference between someone simply taking the blue pill and an ‘Austrian’ investor in the current situation is probably that the latter attempts to incorporate all possible outcomes in his strategy, instead of trusting that central bank interventionism will continue to ‘work’ for investors.
“We believe that there is a grave danger associated with simply ‘taking the blue pill.’ First of all, in the context of ‘risk assets,’ having faith in central bank magic is most definitely not a contrarian position anymore – less so than at any other time in the past six years. Contrarian views have actually worked very well in treasury bonds and crude oil in 2014, so it would also be quite wrong to state that ‘contrarianism no longer works’ as a general proposition. The majority is of course always right during a strong trend. However, there inevitably comes a time when a trend has lasted long enough and gone far enough that the ranks of doubters have been thoroughly thinned out and the majority ceases to be correct.
“We perceive a ‘greater tolerance for short term drawdowns’ as quite dangerous in connection with risk assets at this juncture. In asset bubbles there are usually a number of short term breakdowns that are immediately followed by prices moving to new highs, a fact that greatly cements the confidence of market participants – usually to the point where it becomes fateful overconfidence. The main problem with this ‘tolerant’ approach is that one simply cannot differentiate a run-of-the-mill short term correction from a short term downturn that ends up heralding something far worse. Initially, all corrections look similar… The initial downturn is never seen as a cause for alarm. Sometimes this can however be followed by a decline so swift that having a tolerance for drawdowns can end up leaving one with very big losses in a very short time period.
“Such sudden reassessments of market valuation can rarely be tied to specific fundamental developments. Rather, anything that is reported is all of a sudden interpreted negatively and becomes a trigger for more selling, even though similar news would have been shrugged off a few days or weeks earlier. After all, nearly every economic news item can be interpreted in a number of different ways, so that even superficially good news can become a problem (in the current situation they could e.g. create fears of a faster tightening of monetary policy).
“We will readily admit that one cannot know with certainty whether the bubble in risk assets will become bigger. However, it seems to us that avoiding a big drawdown may actually be more important than gunning for whatever gains remain. One can of course endeavor to do both, but that inevitably limits short term returns due to the cost of insuring against a potential calamity.”
My own view is that Hendry and Tenebrarum are both right – only that the appropriate pill is conditional on the state of investor preferences toward risk-seeking and risk-aversion – preferences that can be largely inferred from observable market action. In an environment where market internals and credit spreads are deteriorating, betting on risky assets is extraordinarily dangerous and subject to abrupt air-pockets, free-falls and crashes – the “sudden reassessments of market valuation” that Tenebrarum correctly recognizes. That’s what we presently observe, and it demands the red pill that makes one conscious of the painful reality of the present situation. But those conditions may change, and in that case, the immediacy of our concerns should ease accordingly.
There is one main lesson that should be drawn from our own experience in recent years – and it is a lesson that can be demonstrated across every bubble-crash cycle in history. In an environment where internals and credit spreads uniformly convey risk-seeking preferences, the market may be severely overvalued, but pointed expectations about impending losses are best deferred. That doesn’t mean swallowing the blue pill whole or living in the untethered world of speculative fantasy. It would surely require insurance or some other safety-net at current valuations, but there is a tendency for overvalued markets to become more overvalued in that environment. For now, we view the market as vulnerable to vertical losses. That risk will change with market conditions, and we will take that evidence as it emerges.I’ll repeat emphatically what I noted a few weeks ago. The set of market conditions that we observe at present are supportive for steep losses to emerge because present conditions join compressed risk premiums with a measurable shift toward risk-aversion by investors. If further speculation is to emerge – and this is borne out even in data from recent years – that speculation is likely to be supported by a measurable shift toward risk-seeking that can also be inferred from the behavior of observable market internals. We need not hope for a major market decline, nor do we need to dread a major resumption of speculation. Each of these will manifest because conditions are supportive for them to manifest. As the Buddha said, “This is, because that is. This is not, because that is not.”
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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