Priming The Natural Bubble Tendency

No Equity Bubble Yet.....

Do record levels on the S&P 500, elevated equity valuation levels and negative bond yields indicate that financial markets are in a bubble? Looking at the movements in the real S&P 500 relative to a ten-year moving average, or even over a twenty-year period, would suggest not. By the time bubbles are statistically identifiable, though, the risk-reward has already tilted against investors. Far more useful is to pinpoint the lead indicators. These are not measured by financial ratios or statistical analysis, but by herding among investors. On that basis, an equity bubble is indeed brewing.

In its “Financial and Stability Report” published in April 2015, the IMF warned of the widespread herding that has beset the U.S. mutual fund industry since 2009. Well in advance of the 2008/9 Great Recession, the ECB noted the same behavior among hedge funds. Even risk managers are not immune. The collapse of the US housing market was the catalyst for the Great Recession. But the na?ve assumption that investing in securitized instruments represented a diversification of risk exposure to housing was the transmission mechanism. More often that not, hedging will result in a concentration of risk, as everyone tends to use the same instruments.

.... But There Are Some Powerful Incentives And Disincentives.

Are these behaviors inevitable? Evolutionary psychology would indicate so. In which case, identifying the bubble candidates early in the cycle is the key to successful investment. We all love the hug of the crowd and are social animals. Marketing professor Jonah Burger even went so far as to claim that others shape ninety-nine percent of our behaviours, and for the most part that we are blissfully unaware of these influences, in his recent work "Invisible Influence: The Hidden Forces That Shape Behaviour."

But in the current cycle, there have some particularly powerful financial incentives and disincentives to reinforce our natural behaviour. Three stand out: high levels of economic uncertainty; overly easy monetary conditions; and restrictions on bankers’ rewards, which were designed to reduce risk, but in combination with easy monetary conditions, may inadvertently have the reverse effect.

Behavioural economist Richard Thaler in his book “Misbehaving”, laments that behaviorual economics has of yet, not offered much insight into macroeconomics. In furthering our understanding of crowd psychology and how excesses develop, though, it would seem to have a lot to contribute. Bubbles form because of social proof, or the observation that the majority of the time individuals instinctively feel more comfortable with the security of the crowd. Herding in the early development of humankind provided protection against a hostile world, a behaviour that sits well with today’s treacherous markets and job insecurity within the financial services industry.

Social Proof Is Irrational, But Pre-programmed...

Investors mimic the behaviour of others, on the often unconscious assumption, they must know something that they are unaware of. From an economic perspective, of course, following others’ lead is only rational if an individual knows all the information that others know. If not, the result is a market cascade that may be entirely at odds with the underlying fundamentals.

The Nobel laureate Robert Shiller provides an excellent explanation of this behaviour from a slightly different perspective. Using the example of two new restaurants, which open side by side, he demonstrates how one restaurant might succeed at the expense of the other, purely as a result of erroneous assumptions that culminate in an information cascade. The first patron arrives outside, cannot choose between the two restaurants and plumps for one on the basis of a hunch. The second customer then enters the scene and notes that one restaurant has at least one client, follows his example, and so the cascade continues. If the restaurant fails to live up to its erroneously received reputation, the consequences are predictable.

...And It Flourishes In Uncertainty.

The key takeaway from the restaurant example is that social herding flourishes in an environment of uncertainty typical of modern economies in the post-Great Recession era. Since 2009, the global economy has been in uncharted territory, with no precedent for the massive expansion in central bank balance sheets, or for the headwinds to economic activity from declining population growth, rising inequality, the destructive impact of the digital economy on jobs, and high levels of personal and public debt.

When monetary conditions are easy, it is not unusual for financial markets to decouple from the real economy, as excess money balances spill over into purchases of financial assets. This type of behavior is usual of the late stages of bull markets, with expanding multiples eventually clashing with tightening monetary conditions. But it is atypical, but not surprising, for the decoupling to last long as it has in the current cycle.

Weak economic growth and negative interest rates have spurred a voracious appetite for yield, with the dividend yield on the S&P 500 now more or less matching the 30-year Treasury yield. There is simply no incentive for holding long-term debt when the term premium is negative, never mind when rates are negative, as is the case in large parts of Europe, as well as Japan.

For equity investors, an important driver of this behavior has been dubbed TINA (“There-is-no-alternative”). With no outlet for the excess liquidity in the face of negative or abnormally low rates, investors are forced into the market, even though the case for equities rests on expensive bond markets. There may no bubble yet, but TINA seems suspiciously to us like an example of Kindleberger’s "new age story" that has been used to rationalize excesses in past cycles.

US Earnings growth has been declining, and with margins contracting, it is unlikely it will provide a rationale for holding equities anytime soon. The only solution is to ignore the real economy. And if investors have acquired a learned behavior stemming from the Greenspan put, becoming the Bernanke put, and finally the Yellen put, why not? Even if the Fed raises rates in December, they will still be negative in real terms and well below neutral.

Uncertainty Stimulates Reflexive Thinking

Cognitive psychology can supplement social psychology in understanding how this occurs. Uncertainty breeds instinctive, rather than effortful and thoughtful thinking. In his seminal work “Thinking Fast and Slow”, Daniel Kahneman, distinguishes between two types of cognitive activity. System one type thinking has an evolutionary element focused around personal preservation, as well as learned behaviors stemming from repetition. It emanates from the mid-brain which is evolutionary well developed and houses the “fight-or-flight” response, in addition to our medium- and long-term memories.

System two type thinking, by contrast, is deliberate, effortful and tiring. When individuals are stressed, confused or even just time starved, it loses out to system one because it stems from the less well-developed frontal cortex. Heuristics such as “buying-on-dips”, therefore triumph over questions as to whether prices are fundamentally justified, based on a reflexive assumption the Fed will always bail you out.

It is this destructive combination of central bank incentives and uncertainty, which lies at the center of the mispricing of equities currently. And ironically, it could even be made worse by capping bankers’ bonuses.

Banker Bonus Caps Could Have Unintended Consequences

While reducing incentives may foster less risk taking, it may also encourage investors to travel with the crowd. The behavioral school of psychology has long since demonstrated how infrequent rewards have a much greater incentive effect than compensation that is regular and scheduled. If monetary policy is overly accommodative and incentives are weak, though, it is not in investors’ interests to go against their natural instincts of traveling with a bullish cascade.

Invest too heavily in defensive holdings, short positions, or even holding high cash reserves, and get it wrong and you lose your job. Get it right and your upside is limited, so most will do what they are in case programmed to do, and follow everyone else. All lose as a result of the inevitable unwind of the bubble, but the ultimate client is hurt first.

Until policy makers abolish these disincentives, or monetary policy ceases to underwrite moral hazard, another dip followed by yet another move to new highs may be the inevitable result. Erroneous incentives and disincentives combined with imprinted behavioral responses make another bubble almost inevitable.

Buyer Beware

Of course, a bubble may be the inevitable price to be paid for creating the inflation that provides the incentive for households to go out and spend. However, the victory will be short-lived. Its financial consequences could ultimately make the deflation worse as the bond markets unravel and a negative wealth effect kicks in from the resulting fallout in equities. In the interim, profitable investment opportunities can still be exploited. But more than ever, it is a case of "buyer beware."