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Monday, January 05, 2015 1:17 PM

Red Pill, Blue Pill, Cognitive Dissonance, Pavlov's Dogs

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I received an email a few weeks ago stating "Hussman has been so wrong I should stop quoting him."

Nonetheless here I go again, because I think Hussman has something important to say. Please consider a few admittedly lengthy snips from his post today Pills for Cognitive Dissonance in a Speculative Bubble.

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. 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.

[From Yes, This is an Equity Bubble]

One would think the Federal Reserve would have learned from that catastrophe. Instead, the Fed has spent the past several years intentionally trying to revive the precise dynamic that produced it. As a consequence, speculative yield-seeking has now driven the most historically reliable measures of equity valuation to more than double their pre-bubble norms. Meanwhile, as investors reach for yield in lower-quality but higher-yielding debt securities, leveraged loan volume (loans to already highly indebted borrowers) has reached record highs, with the majority of that debt as “covenant lite” issuance that lacks traditional protections in the event of default. Junk bond issuance is also at a record high. Moreover, all of this issuance is interconnected, as one of the primary uses of new debt issuance is to finance the purchase of equities.

At present, the most historically reliable valuation measures are more than 100% above pre-bubble historical norms. Investors who dismiss present market valuations by reflexively parroting the phrase “lower interest rates justify higher valuations” haven’t thought carefully about the problem or done the math, and that math is just basic arithmetic.

Make no mistake – this is an equity bubble, and a highly advanced one. On the most historically reliable measures, it is easily beyond 1972 and 1987, beyond 1929 and 2007, and is now within about 15% of the 2000 extreme. The main difference between the current episode and that of 2000 is that the 2000 bubble was strikingly obvious in technology, whereas the present one is diffused across all sectors in a way that makes valuations for most stocks actually worse than in 2000.

[End Yes, This is an Equity Bubble - Back to Cognitive Dissonance]

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 in Hugh Hendry and the “Blue Pill”:
“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.
Pavlov's Dogs

My take on the switch by Hugh Hendry is along the lines of Pavlov's Dogs Classical Conditioning.

In his initial experiments, Pavlov rang a bell and then gave the dog food; after a few repetitions, the dogs started to salivate in response to the bell. Pavlov called the bell the conditioned stimulus because its effects depend on its association with food.

As related to the stock market, every time stocks dipped, bears thought "this was the one". Yet, every dip was nothing more than a bell-ringing buy opportunity, often times coupled with lovie-dovie statements by someone on the Fed.

Even minor dips were bell-ringers. Finally, at long last Hendry has been trained.

Right on Cue

And sure enough, right on cue today, San Francisco president Fed’s Williams says Rate Hikes Should be Gradual Because Economy Still Needs Help.

Whether Williams is purposely attempting to smooth the stock market is subject to debate. What's not subject to debate is past reactions. Many stock market reversals over the past few years have come from similar Fed statements.

Today we don't see one, at least yet. Curiously the dollar and gold are both up. The Dow was down over 300 points but has recovered a bit.

As always, one day proves nothing. But that's the problem for those on the blue "buy the dip" pill isn't it?

One never knows when this is the dip that isn't bought. When the final dog has been trained, the pool of dip buyers is exhausted. Yet, investors (aka fully trained dip buyers), keep expecting reversals that don't come, deploying more and more cash all the way down.

Was Hugh Hendry the final dog?

Mike "Mish" Shedlock

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