Equity Markets Give a Lesson in Behavioral Psychology
Coronavirus, Stock Market Strength, and Elevators
Back in 1962, the TV show Candid Camera used its hidden cameras as part of a scientific study to learn about human behavior. Along with three of the show’s actors and some unsuspecting passersby, what they discovered was both revealing and entertaining. It also provides an essential understanding of human behavior that impacts investment decisions. In a black and white episode, the show helped in one of a series of trials called the Asch conformity experiments. Candid Camera’s episode was titled “Face the Rear.” Dr. Solomon Asch had been conducting different tests at Swarthmore College as part of his research for over six years. Through his various social behavior trials, he was able to gauge the apparent human disposition to conform. The different scientific experiments yielded some useful results for understanding what may be driving the stock market 58 years later.
In “Face the Rear,” the Psychologist had two actors enter an elevator and take the abnormal position facing the back wall (not the door). They then waited for an unsuspecting test subject to enter the elevator; at this point, a third actor would board the lift and also face the back wall. With no encouragement, other than “fitting in,” the test subjects would, consistently, look around, then decide “by themselves” to also turn and face the back wall of the elevator. This information about human behavior may shed light on the strength of today’s equity markets.
Investors are Facing the Rear
Over the past few months I’ve been speaking to self-directed investors, fiduciaries, fund managers and other market players whose analysis I respect. Our discussions have struggled to uncover the reason for this years relentless upward climb in stocks. Most of these experienced investors and traders agree; all factors considered, they’d expect the market to be, at best, cautiously optimistic. At worst, searching each day for a new bottom. We’re all guessing at what does not, given what we all know, make sense. The conjecture offered includes high savings rates, supportive Fed policy, “it’s all big tech,” “the vaccine is near,” forward-looking investors, etc. However, we all believe there is nothing in recent market highs that conforms to past market behavior.
The other day I tried a different approach and got different results. I thought, perhaps we’re all asking the wrong question. We’ve been asking why the market is going up in spite of some of the most negative and uncertain economic conditions in history. We actually already know the answer; the stock market goes up when there are more buyers than sellers. It’s that simple. So the better question, what we really are trying to learn is, why the heck are there more buyers than sellers?
Everyone's Going Up
The science of economics pays a lot of attention to statistics that measure hard data. It’s a social science, but it can only count what can be counted. And it can only count that after the fact. It’s a discipline with its predictive basis in supply and demand, and a portion of demand is driven by crowd psychology. The herd doesn’t always face in the direction you’d reasonably expect. But the human need to conform, as Dr. Salomon Asch proved with six years of various experiments, is a part of being human. Additionally, follow-through of market trends is driven largely by what is “working” at the time. Investors’ expectations of other investors’ future actions is how money is made. There is no right or wrong; if the crowd is moving in one direction, that is the right direction (for now). Herd behavior is the best answer I’ve found for the question, “why are there more buyers than sellers?”
The main ingredient and action from investors that create speculative bubbles, even when many investors feel the sentiment is incorrect has always been the desire to do what other investors are doing. At the extreme, price bubbles then grow, and acceptable valuations get redefined. Then the fear-of-missing-out behavior creates worry, even among contrarians. Logic can be found, but it isn’t driving behavior any longer. One by one, logical investors may move in a direction that they are not comfortable with because that has been the easiest path, despite concerns.
Let’s Blame the Media
It has become fashionable to blame the media for everything. In the spirit of herd behavior, for this section, please allow me to join the blame-the-media herd. Rest assured, to be even more convincing, I’ll quote experts - which is always in fashion.
Nobel Laureate in economics, Professor at Yale University, and co-creator of the Case-Schilling Index of House Prices recently wrote:
“…most people have no way to evaluate the significance of economic or scientific news. Especially when mistrust of news media is high, they tend to rely on how people they know respond to news. This process of evaluation takes time, which is why stock markets do not respond to news suddenly and completely, as conventional theory would suggest. The news starts a new trend in markets, but it is sufficiently ambiguous that most smart money has difficulty profiting from it.” – Robert J. Schiller, Understanding the Pandemic Stock Market
Mr. Schiller believes people look to their peers rather than blindly follow talking heads on TV. We’ve seen this occur with peer groups on message boards and social media as they have bought stocks of bankrupt and near-bankrupt companies. Previous logic and methodology would suggest these companies should have been avoided. The mainstream news sources have continually poked fun at this group of online investors, but the short track record thus far has validated their actions. In a June 15th conciliatory article, CNBC quoted the head of Quantitative Research at Societe Generale:
“For all the mocking of Robinhood investors, their timing back into the market looks impeccable, with a significant pick-up in holdings as equity markets bottomed in mid-March” – Andrew Lapthorne
When it comes to financial markets and other, more dubious, money-making plots like chain letters and Ponzi schemes, money continues to be made as long as there is new money to be found. So, for as long as market participants are following each other, the current bullishness will persist. There is, of course, a finite amount of US Dollars, so in theory, upward movement cannot last forever. However, with interest rates near zero, there is still plenty of investable cash returning less per year than stock market participants earn in a day. That is a strong incentive to consider equities when you may not otherwise have.
Price discovery of all kinds is, in part, based on consumer or investor alternatives. When the masses are choosing one item over another, their decisions impact price direction, and price direction depends on the environment. A bag of popcorn at a movie may cost three times the price of making and eating it at home, but the alternative is not eating popcorn at the movie or eating other more expensive items available. So the current price works. No one would pay $6.50 for a bag at home. Should people suddenly not buy it at current prices, the theater has plenty of room (over their cost) to lower what they charge movie-goers until they hit the price where it is again being purchased. The same is true for wine at a restaurant, soda at MacDonald's, and everything else. That is everything except a large portion of the bond market. The Fed is controlling a large swath of prices of the bond market; they are not market-priced. The central banks promise to keep rates at zero and flatten the curve by setting a yield target over which they may have a running bid to all sellers, prevents this area of the curve from being market-priced. It is instead artificially priced.
There has been an increased demand for borrowing, individual loans, and small business loans. Corporate loan demand is still strong, but weaker than earlier in the year. This increase in borrowing demand, especially with weakened credit ratings and scores, should put upward pressure on the cost of money. Interest rates would be expected to rise. Yields are below what typically can be expected in the bond market. The higher price of bonds is different than the higher price of stocks. The difference is that the Fed admittedly is rigging the bond market prices. Crowd behavior and other inputs have been replaced with government fine-tuning.
Stock prices are not overtly rigged, but they are tied to interest rates and other alternatives to investing. This impacts investor decisions across all assets.
In the TV episode discussed earlier, people entering the elevator, clearly befuddled, slowly turned around and faced the rear of the elevator. But the experiment did not stop there. In one of the elevator rides, the Candid Camera actors onboard removed their hats (it was 1962). The unwitting rider did the same. When they placed their hats back on, the strength of following the crowd caused the rider to then place their hat back. Crowd psychology, whether it is fitting in, or following peers you trust, is powerful. No amount of looking at lagging and leading indicators, P/E ratios, stochastics, or logic can compete with that.
For now, crowd behavior is the freight train driving the market upward. It may last months; it may change tomorrow. This behavior, like elevators, runs in two directions. Those entering near the top may be putting more at risk than those who entered at ground-level.
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