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On the morning of May 6, 2010, mayhem erupted on the streets of Athens, Greece. Later that day, the Flash Crash occurred, sending the U.S. stocks markets down by 9% intraday. A random coincidence? The data suggests not.
Investing is an activity of forecasting the yield over the life of the asset; speculation is the activity of forecasting the psychology of the market.
~ John Maynard Keynes
Like that May day in 2010, the spectre of default risk raised its head this month. Chinese equities plummeted, Grexit appeared imminent, and even little Puerto Rico contributed a scare. Institutions have a limited power to save us from ourselves, as this excellent article by Jason Zweig recounts, and investors were again reminded that the surges of emotion through markets - especially fear- can drive prices dramatically. A global risk-off movement took hold briefly, and given the disquiet produced by events in China and Europe, it is probable that the volatility is only beginning.
Risk-on behavior is a collective pursuit of financial safety, while risk-off describes the flow of capital to momentum-driven and higher yielding securities. Periods of risk-off are catalyzed by a growing sense of unpredictability, increasingly negative news flow, and rapidly falling prices.
Today's newsletter looks at how a seed of doubt, once germinated, can begin to choke investors with tendrils of fear. We examine a sentiment-based sell signal in China before the recent downturn which is similar to a signal seen before the May 2010 Flash Crash. The question for investors on the sidelines of such panics is when to "catch the falling knife" and buy into the fear. Evidence shows that Warren Buffett is correct to counsel us to "buy on fear," but ONLY when fundamental valuations are also attractive, which we demonstrate through recent research.
Austerity makes the economic and psychological damage worse for Greeks, and it not only impairs the ability to repay, but it is also unnecessarily punitive. With a mandate from Greek voters to spurn the austerity program and the reticence of creditors to bend due to fears of moral hazard, the only sensible way forward is default. Greece simply cannot (and should not) pay what it putatively owes. If default happens this month, would all be lost in "Europe's Lehman moment?" Would that shattered trust lead to plummeting stock markets and interest rates and a massive global flight to safety? It has boiled down to a crisis of trust, and for that reason, it presents tremendous opportunity.
In an earlier newsletter we examined how mistrust in leadership is a contrarian predictor of stock prices. In today's newsletter we discuss shattered trust generally. Trust is more resilient than might be expected. And for investors, shattered trust presents tremendous opportunities.
The celebrated author and humorist Samuel Clemens (pen name Mark Twain) documented his experiences in the Nevada mining stock bubble, and his writings are one of the earliest (and certainly the most humorous) firsthand accounts of involvement in a speculative mania.
Evidence of bubbles has accelerated since the [2007-2009 financial] crisis.
~ Robert Shiller ("Irrational Exuberance," 2015).
After a brief stint as a Confederate militiaman during the beginning of the U.S. Civil War, Clemens purchased stagecoach passage west, to Nevada, where his brother had been appointed Secretary of the Territory. In Nevada, Clemens began working as a reporter in Virginia City, in one of Nevada’s most productive silver- and gold-mining regions. He enviously watched prospecting parties departing into the wilderness, and he quickly became “smitten with the silver fever.”
Clemens and two friends soon went out in search of silver veins in the mountains. As Clemens tells it, they rapidly discovered and laid claim to a rich vein of silver called the Wide West mine. The night after they established their ownership, they were restless and unable to sleep, visited by fantasies of extravagant wealth: “No one can be so thoughtless as to suppose that we slept, that night. Higbie and I went to bed at midnight, but it was only to lie broad awake and think, dream, scheme.”
Clemens reported that in the excitement and confusion of the days following their discovery, he and his two partners failed to begin mining their claim. Under Nevada state law, a claim could be usurped if not worked within 10 days. As they scrambled, they didn't start working, and they lost their claim to the mine. His dreams of sudden wealth were momentarily set back.
But Clemens had a keen ear for rumors and new opportunities. Some prospectors who found rich ore veins were selling stock in New York City to raise capital for mining operations. In 1863, Clemens accumulated stocks in several such silver mines, sometimes as payment for working as a journalist. In order to lock in his anticipated gains from the stocks, he made a plan to sell his silver shares either when they reached $100,000 in total value or when Nevada voters approved a state constitution (which he thought would erode their long-term value).
In 1863, funded by his substantial (paper) stock wealth, Clemens retired from journalism. He traveled west to San Francisco to live the high life. He watched his silver mine stock price quotes in the newspaper, and he felt rich: “I lived at the best hotel, exhibited my clothes in the most conspicuous places, infested the opera. . . . I had longed to be a butterfly, and I was one at last.”
Yet after Nevada became a state, Clemens continued to hold on to his stocks, contrary to his plan. Suddenly, the gambling mania on silver stocks ended, and without warning, Clemens found himself virtually broke.
"I, the cheerful idiot that had been squandering money like water, and thought myself beyond the reach of misfortune, had not now as much as fifty dollars when I gathered together my various debts and paid them."
Clemens was forced to return to journalism to pay his expenses. He lived on meager pay over the next several years. Even after his great literary and lecture-circuit success in the late nineteenth century, he continued to have difficulty investing wisely. In later life he had very public and large debts, and he was forced to work, often much harder than he wanted, to make ends meet for his family.
Clemens had made a plan to sell his silver stock shares when Nevada became a state. His rapid and large gains stoked a sense of invincibility. Soon he deviated from his stock sales plan, stopped paying attention to the market fundamentals, and found himself virtually broke.
Clemens was by no means the first or last person to succumb to mining stock excitement. The World’s Work, an investment periodical published decades later, in the early 1900s, was beset by letters from investors asking for advice on mining stocks. The magazine’s response to these letters was straightforward: "Emotion plays too large a part in the business of mining stocks. Enthusiasm, lust for gain, gullibility are the real bases of this trading. The sober common sense of the intelligent businessman has no part in such investment." (from Meir Statman)
While the focus of market manias changes - mining, biotech, Chinese stocks, housing, etc… - the outline of a speculative bubbles remains remarkably similar over the centuries. Today's newsletter examines the latest research into speculative bubbles and looks at how we can apply that knowledge, with examples of the recent booms (bubbles?) in Chinese stocks and Biotech. This newsletter is much longer than usual letter, in part because the topic is both complex and important. Skip ahead to the end for the Chinese and Biotech conclusions. A more thorough treatment of bubbles is in my next book, coming out in late 2015.
Multilevel marketing preys on a suspension of disbelief. The radio show “This American Life” ran a report on a multilevel marketing venture called “WakeUpNow” (WUN). WUN’s business was very difficult for the reporters to ascertain. It appeared to be cultivating a positive belief that one could convince others to hold the same positive belief (and pay for a monthly subscription while doing so). The radio story about the company reveals the psychology behind the multi-level marketing of belief. The company now appears shuttered.
“Herbalife: the customers are fictitious, the business opportunity is a scam, the university degree is a fraud.”
~ Bill Ackman
Herbalife (HLF) is the best-known multi-level marketing company. Bill Ackman, a successful hedge fund manager, took a $1 billion short position in HLF in 2012. He claimed that Herbalife is multi-level marketing scam that preys on the poor and the ignorant. Others joined him. Per The Atlantic magazine in 2014, critics claim “Herbalife is targeting groups who are easily victimized by false promises of riches.” On the other side, Carl Icahn accumulated a 17% stake in Herbalife and claimed it was a legitimate business.
Again according to The Atlantic, “Fundamentally, Herbalife targets our cognitive weaknesses, though which weaknesses is a subject of debate.” HLF is not unlike many other businesses (payday loans, tobacco, etc…) that prey on biases. HLF and WUN are selling positive belief – the belief that one can get rich through effort and chutzpah.
Imagine awakening from a concussion to find that your spouse has been replaced by an imposter. Besides a minor headache you have no other problems - just that one. A stranger is pretending to be your spouse. She looks, talks, and lives exactly like your spouse, but you know - deep down - she’s not your spouse. Of course it doesn’t make sense intellectually that your spouse was replaced by a double, but you absolutely feel that way.
Capgras syndrome is the name for this disorder, and it is characterized by a delusional belief that a loved one has been replaced by an imposter. The feelings of strangeness win out over the intellectual understanding that this person looks and acts identically to your spouse.
For those with Capgras Syndrome, a break in brain circuitry disconnects the facial recognition area from the limbic system. The face of a loved one usually elicits an emotional response - joy, excitement, love. But after a blow to the head (or other neurological issue), this feeling is no longer experienced. Patients see their spouse with their eyes, but they don’t feel anything. In fact, while the skin of a normal person shows evidence of physiological arousal (slight sweating) when the image of a loved one is viewed, the skin conductance of those with Capgras’ Syndrome stays flatlined.
Because Capgras’ sufferers see the exact person (“yes, she looks just like my wife”) but don’t feel recognition (“I know she’s not my wife”), a battle ensues between reason and emotion in the brain. You might expect them to get on with life, living with the intellectual assurance that this person clearly must be their spouse. When everyone around them insists “this is your spouse, not a fake!” – that should hold some weight. But the brain accepts emotional input as superior to visual/intellectual input, and the patient remains doubting.
Because the Capgras’ patient feels no connection with the loved one, the only rational explanation (to the brain) is that she must be an imposter, a double. And the mind tends to attribute sinister motives to the imposter: “What did she do to my real wife?!” which can lead to violent behavior. An elaborate story is fabricated out of a simple disconnect.
But Capgras patients are not always upset by the imposters. One man with Capgras reportedly confessed to his priest that he had repeatedly been unfaithful to his wife – he had been sleeping with his wife’s doubles.
As investors we are often confronted with what we know to be true intellectually versus what we feel emotionally. “I know this market is overvalued on a historical P/E basis, but I feel like it will still go up.” Even as experienced investors who know we should rely on the intellectual assessments, the pull of emotional reasoning - reinforced by the media - is strong. As you can see in our ETF model below, the best investing opportunities come when we trade against both the emotions and the intellect of the media. This week’s newsletter examines the battle of reason and emotion, how that plays out in events such as a potential Greek default, and the cycles of belief that drive ETF prices.
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