Applying Emotional Intelligence to the Boom Bust Cycle

One of the myths perpetuated by those who can’t explain the behavior of markets is to resort to the “emotions” fallacy.

A good example as I pointed out is this comment[1]

Hong Kong financial official K.C. Chan urged investors to “stay calm” and not be “spooked by the market”

These people are mistaking effects as the cause. Markets don’t spook people. That’s because markets are essentially people and market price signals represents the collective actions of people. People react to markets out of certain stimulus or incentive. People don’t get euphoric or frightened for no reason.

A good example can be seen below

A fight or flight response by our brain is always result of a stimulus or incentive to act or react.

As I earlier wrote[2],

When uncertainties or the prospect of peril emerges, our brain’s amygdala responds by impelling us either to fight or to take flight. That’s because our brain has been hardwired from our ancestor’s desire for survival—they didn’t want to be the next meal for predators in the wild.

Applied to the present state of the markets, the legacy of our ancestor’s base instincts still remains with us.

So when people’s collective action results to a stock market crash, that’s because there has been an underlying uncertainty or imbalance which these participants see as having “baneful” impact to their portfolio holdings. Such stimulus or incentives triggers the amydgala’s fight or flight response even on the marketplace.

Hence if crashing markets are seen as an ephemeral episode unsupported by fundamentals then many buyers are likely to step in and put a floor to the prices. People who say that markets have been “irrational” or “emotional” are only appealing to their interventionist intuitions.

Yet if crashing markets are seen as fundamentally driven, then the crash dynamic will continue. Interventions such as the recent ban on short sales will fail[3] which 4 European nations recently applied to bank and financial issues[4].

Differentiating Short and Long Term

In addition, one cannot coherently argue that the long term outcome of markets is rational while short term outcomes are emotive (or irrational). To apply this to Warren Buffets’ celebrated commentary,

In the short run, the market is a voting machine but in the long run it is a weighing machine.

Every action by individuals contains elements of emotion. That’s because our actions are always designed to replace the current state of uneasiness. Content or discontent signify as emotional states. Emotions are simply part of individual actions. Thus seen in a collective sense, markets are always ‘emotional’ even during ‘normal’ days. Perhaps it is only in the degree where the nuances can be made.

To add, since the long run represents the cumulative effects of short run actions, there has to be a smoothing out effect for the long run actions to dominate.

Applied to Mr. Buffetts’ axiom, for the weighing machine effect to prevail over the long run, the series of short term ‘weighing machine’ dynamics has to dominate the series of short term ‘voting machine’ actions. Or the probability of distribution has to skew towards forces of the weighing machine dynamic otherwise the voting machine effect will takeover.

Boom Bust Cycles Have Real Effects

The state of the US markets appears to be revealing on such symptoms, a nice illustration can be seen in the chart below.

US markets have become nearly an “all or nothing” pattern, where market breadth reveals that stock prices in general either floats or sinks in near simultaneously during volatile days.

As Bespoke writes[5], (bold emphasis mine)

Whenever the market has a day where the net advance/decline (A/D) reading of the S&P 500 is greater than 400 or less then negative 400, we call it an 'all or nothing' day. During the credit crisis, all or nothing days were incredibly common. In 2008, we saw a peak of 52 all or nothing days, which works out to an average of about one per week. Since then, we have seen a decrease in the number of all or nothing days, but they still remain elevated.

So far this year there have been 27 all or nothing days, which works out to a still elevated annualized rate of 43. At this time just last month, there had only been 17 all or nothing days this year, which at an annualized rate of 31 would have been the lowest level since 2007. Back then, many investors were hoping that the market was finally returning to pre-crisis levels of normalcy.

As one would note from the above, current markets have hardly been about earnings, as cluster based movements represent as the NEW normal where markets have been latched to political actions more than from market forces as dogmatically embraced by mainstream.

In short, this exhibits more evidence of the increasing dependency of the S&P 500 to political interventions as a major force in influencing equity prices.

As the great Murray N. Rothbard wrote[6],

In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time. The "boom-bust" cycle is generated by monetary intervention in the market, specifically bank credit expansion to business.

Remember, boom bust policies impacts not only the financial markets but has real impact to the economy. Through the manipulation of interest rates, patterns of consumption and savings and investment, wages, relative price levels at every stages of production, capital structure, earnings, and etc., are directed away from consumers preferences and rechanneled into stages of capital goods sector where politically directed actions would now signify as distortion of prices, miscoordination of resources or as malinvestments which eventually would have to be liquidated.

Again Mr Rothbard,

If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained. But this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, and there is no reason to think that they have, people will rush to spend the higher incomes in the old consumption-investment proportions. In short, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.

Today’s market environment has accounted for as the continuing saga of the 2008 liquidation phase which has been constantly delayed, deferred and partly absorbed by government through sundry interventions and systemic inflationism designed to save the fragile, broken and unsustainable system.

And the effects of the gamut of political interventionism has been manifesting into the actions of equity markets.

Everybody can wish for the old days, but prudent investors would need to face up with reality or take the consequences of ideological folly.

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[1] See Japan's Minister Calls for More Inflationism to Stem Global Market Crash, August 19, 2011

[2] See Managing Risk and Uncertainty With Emotional Intelligence, March 20, 2011

[3] Bespoke Invest, A Rough Week For European Banks, August 19, 2011

[4] See War against Short Selling: France, Spain, Italy, Belgium Ban Short Sales August 12, 2011

[5] Bespoke Invest, 'All or Nothing' Days on the Rise, August 16, 2011

[6] Rothbard, Murray N. The Positive Theory of the Cycle, Chapter 1 America’s Great Depression

Video: Understanding Human Action (Praxeology)

Here is a short video explaining human action (praxeology) [sourced from Mises Blog]

From Ludwig von Mises (bold emphasis mine)

Choosing determines all human decisions. In making his choice man chooses not only between various material things and services. All human values are offered for option. All ends and all means, both material and ideal issues, the sublime and the base, the noble and the ignoble, are ranged in a single row and subjected to a decision which picks out one thing and sets aside another. Nothing that men aim at or want to avoid remains outside of this arrangement into a unique scale of gradation and preference. The modern theory of value widens the scientific horizon and enlarges the field of economic studies. Out of the political economy of the classical school emerges the general theory of human action, praxeology. The economic or catallactic problems are embedded in a more general science, and can no longer be severed from this connection. No treatment of economic problems proper can avoid starting from acts of choice; economics becomes a part, although the hitherto best elaborated part, of a more universal science, praxeology.

Political Interventions has Led to the Widening of Divergences in Global Asset Markets

By creating illusory profits and distorting economic calculation, inflation will suspend the free market's penalizing of inefficient, and rewarding of efficient, firms. Almost all firms will seemingly prosper. The general atmosphere of a "sellers' market" will lead to a decline in the quality of goods and of service to consumers, since consumers often resist price increases less when they occur in the form of downgrading of quality. The quality of work will decline in an inflation for a more subtle reason: people become enamored of "get-rich-quick" schemes, seemingly within their grasp in an era of ever-rising prices, and often scorn sober effort. Inflation also penalizes thrift and encourages debt, for any sum of money loaned will be repaid in dollars of lower purchasing power than when originally received. The incentive, then, is to borrow and repay later rather than save and lend. Inflation, therefore, lowers the general standard of living in the very course of creating a tinsel atmosphere of "prosperity.- Murray N. Rothbard

The fascinating thing about markets is that we can always expect the unexpected.

When events don’t play out according to expected patterns, this only shows how people respond differently to even similar conditions. That’s because many variables affect or influence people’s response to evolving conditions.

As the great Ludwig von Mises wrote, (bold emphasis mine)[1]

Epistemologically the distinctive mark of what we call nature is to be seen in the ascertainable and inevitable regularity in the concatenation and sequence of phenomena. On the other hand the distinctive mark of what we call the human sphere or history or, better, the realm of human action is the absence of such a universally prevailing regularity. Under identical conditions stones always react to the same stimuli in the same way; we can learn something about these regular patterns of reacting, and we can make use of this knowledge in directing our actions toward definite goals. Our classification of natural objects and our assigning names to these classes is an outcome of this cognition. A stone is a thing that reacts in a definite way. Men react to the same stimuli in different ways, and the same man at different instants of time may react in ways different from his previous or later conduct. It is impossible to group men into classes whose members always react in the same way.

This is not to say that future human actions are totally unpredictable. They can, in a certain way, be anticipated to some extent. But the methods applied in such anticipations, and their scope, are logically and epistemologically entirely different from those applied in anticipating natural events, and from their scope.

And based on logical and epistemological observations one can observe that the current market conditions are being defined by the deepening signs of divergences.

Divergences in Global Equity Markets

As global markets continue to wobble, most of Asian markets caught fire this week.

Despite Asia’s seeming reanimated equities, individual performances based on recent price actions have been idiosyncratic. In other words, some bourses have recoiled strongly from sharply oversold conditions while the other outperforming bourses have merely shed some the recent languor and could be poised for another upside run.

I would think the Philippine Phisix as representing the second category.

Most of the major bourses, the US S&P 500 [SPX], iShares MSCI All Country Asia ex Japan Index Fund [AAXJ] and the MSCI World (ex USA) Index (EOD) [MSWORLD] have all been on a downdraft almost synchronically since May.

In the past, all markets would have chimed as one.

In contrast the Phisix has swung like a pendulum to erase last week’s losses and post a positive (+2.15%) year to date gains.

Yet based on chart formations, the Phisix appears to be emitting significantly bullish signals. A reverse head and shoulder pattern, which once transgressed or encroached, could possibly send the local benchmark to the 4,900-5,000 level by the year end.

On the other hand, the actions of the BRICs represent the first category where some of the recent gains of Asian bourses signify more of oversold bounces.

China’s (SSEC) and India’s (BSE) spectacular rallies this week, appears to have broken the intermediate downtrend. As to whether the upside breakaway from the current downturns signify as key inflection points remains to be seen.

This will likely be reflected on the commodity markets too.

Divergence in Commodity Markets

Again divergences have likewise been apparent over at the commodity markets.

The recent rally in gold seems to have been thwarted and this has been coincidental to the forcible or manipulated tanking of oil prices which have been due to the International Energy Agency’s [IEA] declaration to release oil reserves in the markets over the coming month[2].

This has been part of the concerted efforts to depress commodity prices since May.

So far the gold and silver remains on the uptrend while oil and the CRB Reuters [CCI] index appears to have broken down.

With the Belgian central bank reportedly having to lease out 41% of their gold reserves, which effectively represents as shorting of gold[3], another political angle with which to manipulate the commodity markets, aside from the setting up for the conditions required for the next wave of asset purchasing program[4], would be to limit the losses being suffered by central banks that have been ‘short’ gold.

But this, in my view, signifies as the secondary order.

On the other hand, the current distortions in the commodity markets brought about by these variable interventions will likely only worsen the commodity economic imbalances and would likely signify a fleeting impact.

To the contrary, this could even setup the gold market for a possible trailblazing run!

Signs of such dynamic can be seen in the unfolding Greece debt crisis where ordinary Greeks have reportedly been stampeding into gold (to even eschew gains from interest rates) just to safeguard their savings from the fear of a collapse of their banking system[5].

QE 2.0 as Bailout of Foreign Banks?

And speaking of the European debt and entitlement crisis, US Federal Reserve Chairman Ben Bernanke recently downplayed the contagion risks of US banks because US banks haven’t been “significantly exposed”. Although Mr. Bernanke admits that US banks have “very substantial exposure to European banks in the so-called core countries, Germany, France”[6].

Given Mr. Bernanke’s very dismal track record and his admission that they “don’t have a precise read” of the performance of the US economy[7], I am pretty confident that his public statements conceals the true nature of intended political actions.

Tyler Durden of Zerohedge.com exposes evidences where money from QE 2.0 have been redirected or diverted to foreign or mostly European banks operating in the US.

Cash holdings of foreign banks based on the US have risen almost in proportion with the US Federal Reserve’s $600 billion QE 2.0.

These intricate diversions have been coursed indirectly through the Eurodollar market via US primarily dealers, US and foreign banks. The US Federal Reserve do not buy assets directly, they are done through agents.

The beneficiary international banks had supposedly been in trouble and require these excess reserves to neutralize the growing risks from the ongoing crisis at the Eurozone.

To quote Mr. Durden[8] (bold emphasis mine, above chart from Zerohedge)

In other words, foreign banks operating in the US have an artificially pumped up cash balance creating a false sense of security, with the fungible cash having been borrowed from abroad. This also means, that when and if European banks realize they need the cash "lent out" to US-based subsidiaries, and demand the $600 billion+ in dollars, all they will see is a white flag of surrender, as the US-operating banks disclose they have pledged the cash for one thousands and one uses, and its sudden withdrawal would end up crashing the capital markets. It also means that explanations that this cash was used by European banks to satisfy regulatory capitalization shortfalls are absolute gibberish. And yes, if and when there is a surge in dollar needs out of Europe, the Fed will have two choices: QE(x) and FX liquidity swaps.

If such claim is true, then we should even expect more QEs to come...and quite soon, given the current tumultuous conditions of the Eurozone.

Also, such actions imply that the US has been very concerned with the developments in Europe enough to engage in QE 2.0 for this reason.

Also, this only goes to show that the US has surreptitiously been in rescuing or bailing out banks across the globe.

Fitting pieces of the puzzle together, we can easily see why a Goldman Sachs alumni has been appointed as the European Central Bank president[9] and why Bank of Japan (BoJ) has imported Ben Bernanke’s dogma of propping up her domestic stock markets by asset purchases as policy[10]—all of which has been meant to rescue the teetering banking system of the world.

If the overall undeclared aim is to survive the current central bank-banking cartel, then there will be NO alternative but for central banks to maintain the asset purchasing programs.

Apparently, the myriad political interventions in the marketplace have led to different effects or the widening of divergent price actions across the global asset markets.

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[1] Mises, Ludwig von Regularity and Prediction, Theory and History; Introduction

[2] See War on Commodities: IEA Intervenes by Releasing Oil Reserves, June 24, 2011

[3] See Belgian Central Bank ‘Lends’ 41% of Gold Reserves, Growing Role of Gold as Money, June 21, 2011

[4] See Poker Bluff: No Quantitative Easing 3.0?, June 5, 2011

[5] See Greeks Go For Gold, June 22,2011

[6] Bloomberg.com Bernanke Sees Small Impact on U.S. Banks of a Greek Default (1), June 22, 2011

[7] See Ben Bernanke Admits to the Knowledge Problem, June 23, 2011

[8] Durden, Tyler The Eurodollar Missing Link: Explaining The QE2-Related Cash Surge In US-Based Foreign Banks, Zerohedge.com June 22, 2011

[9] See Revolving Door Syndrome: European Central Bank’s New Head was Goldman Sach’s Honcho, June 25, 2011

[10] See Bank of Japan’s Interventions in Japan’s Stock Markets, June 23, 2011

Do Americans Buy Stuffs They Don’t Need?

One of the most outrageous obsessions by the mainstream is to substitute statistics for human action then apply political correctness when interpreting them.

This Wall Street Journal Blog should be an example (bold highlights mine)

As it turns out, quite a lot. A non-scientific study of Commerce Department data suggests that in February, U.S. consumers spent an annualized $1.2 trillion on non-essential stuff including pleasure boats, jewelry, booze, gambling and candy. That’s 11.2% of total consumer spending, up from 9.3% a decade earlier and only 4% in 1959, adjusted for inflation. In February, spending on non-essential stuff was up an inflation-adjusted 3.3% from a year earlier, compared to 2.4% for essential stuff such as food, housing and medicine.

To be sure, different people can have different ideas of what should be considered essential. Still, the estimate is probably low. It doesn’t, for example, account for the added cost of certain luxury items such as superfast cars and big houses.

Interestingly, people who spend more on luxuries have experienced less inflation. As of February, the weighted average price of non-essential goods and services was up only 0.2% from a year earlier and 82% from January 1959, according to the Commerce Department. By contrast, the cost of all consumer goods was up 1.6% from a year earlier and 520% from January 1959.

The sheer volume of non-essential spending offers fodder for various conclusions. For one, it could be seen as evidence of the triumph of modern capitalism in raising living standards. We enjoy so much leisure and consume so much extra stuff that even a deep depression wouldn’t – in aggregate — cut into the basics.

Alternately, it could be read as a sign that U.S. economic growth relies too heavily on stimulating demand for stuff people don’t really need, to the detriment of public goods such as health and education. By that logic, a consumption tax – like the value-added taxes common throughout Europe—could go a long way toward restoring balance.

It’s absurd to say that we buy stuff which we don’t need.

While the author does say “different people can have different ideas of what should be considered essential”, he seems confused on why people engage in trade at all.

Moreover, saying that Americans "buy stuffs they don’t need" translates to an ethical issue with political undertones: the author seems to suggest that Americans have wrong priorities or have distorted set of choices! Of course the implication is that only the government (and the author) knows what are the stuffs which people truly needs, thus his justification for a consumption tax! (Put up a strawman then knock them down!)

Although the author attempts to neutralize the political flavor of his article by adding an escape clause: that the stats signify as “evidence of the triumph of modern capitalism in raising living standards”.

People buy to express their demonstrated preference. Yet such preference gets screened from a set of given ordinal alternatives (e.g., 1st, 2nd, 3rd, etc..) from which the individual makes a choice or a decision. And that choice (buying) constitutes part of human action.

As Professor Ludwig von Mises explained, (bold highlights mine)

Action is an attempt to substitute a more satisfactory state of affairs for a less satisfactory one. We call such a willfully induced alteration an exchange. A less desirable condition is bartered for a more desirable. What gratifies less is abandoned in order to attain something that pleases more. That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called costs. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.

If I buy beer (1^st order) at this moment at the cost of my other alternatives: a steak (2^nd order) or a chocolate (3^rd order), does my choice for beer represent stuff I don’t need?

The instance that I made a sacrifice (steak and chocolate) to make a choice (beer) makes my decision part of my act to fill a personal unease or a “need”.

It may not be your need, but it is mine. My actions reflect on my preference to solve my need.

The fact that beer is produced and sold implies that it is an economically valuable product (estimated at $325 billion industry for the world for 2008). Many people “needs” it and would pay (hard earned or otherwise) money for it.

The difference lies in the values ascribed to it by different consumers.

Some see beer as a way to socialize, or a way to get entertained or to get promoted or to close deals or as stress relief or a part of the ancillary rituals for other social activities or for many other reasons as health.

Some may not like beer at all!

The point is people consume or don’t consume beer for different reasons. As an economic good, beer is just part of the ordinal alternatives for people to choose from, aside from chocolate or steak or other goods or services.

Suggesting that beer isn’t a stuff we need, as a beer consumer, severely underappreciates the way we live as humans.

Abraham Maslow proposed that human needs come in the form of a pyramid. He breaks them down into 5, namely physiological, safety, social (love and belonging), esteem and self-actualization.

As the Wikipedia explains, (bold highlight mine)

Maslow's hierarchy of needs is often portrayed in the shape of a pyramid, with the largest and most fundamental levels of needs at the bottom, and the need for self-actualization at the top.

The most fundamental and basic four layers of the pyramid contain what Maslow called "deficiency needs" or "d-needs": esteem , friendship and love, security, and physical needs. With the exception of the most fundamental (physiological) needs, if these "deficiency needs" are not met, the body gives no physical indication but the individual feels anxious and tense. Maslow's theory suggests that the most basic level of needs must be met before the individual will strongly desire (or focus motivation upon) the secondary or higher level needs. Maslow also coined the term Metamotivation to describe the motivation of people who go beyond the scope of the basic needs and strive for constant betterment Metamotivated people are driven by B-needs (Being Needs), instead of deficiency needs (D-Needs).

From my example, my choice for a beer may not signify a physiological (basic need), yet they could reflect on my other deficiency needs (emotion or esteem or social needs).

In other words, B (being)-needs may not be D (deficiency)-needs but they still represent as human ‘intangible’ NEEDS.

Bottom line:

Statistics, which accounts for mainstream’s obsessions, fails to incorporate the intangible or non-material aspects of human nature.

It is, thus, misleading to make the impression that by reducing people’s activities to quantitative equations, or to dollar and cents, patterned after physical sciences, governments can manage society efficiently.

As the great Friedrich von Hayek admonished, in his Nobel lecture “the Pretence of Knowledge” (bold highlights mine)

While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.

Lastly the notion that people don’t know of their priorities seems plain silly and downright sanctimonious.

Besides, governments compose of people too which makes the whole quantitative statistical exercise as self-contradictory.