Comparing Past Outcomes From FED Actions Is A Gambler’s Fallacy

``There are no facts, only interpretations”-Friedrich Nietzche

The euphoria in the global markets following the FED’s actions places a positive spin in an otherwise risk fraught landscape. Should this be instead reckoned as the proverbial “Wall of Worry” to climb?

Equity bulls revert to rate cutting antecedents such as in September 1998 (+25% in 6 months), July 1995 (+11%), June 1989 (+9%) and September 1984 (+5%) as prospective models, where policy actions benefited the equity markets, from which today’s markets could replicate. We hope they are right, but alas, hope is not a strategy.

However, the bulls equally dismiss on the subsequent 2001 tech bust as an “outlier” event for having the infamous 9/11 to “unjustifiably” weigh on the circumstances. Such argument we believe is selective perception or ``how we view our world to create or justify our own reality (Sherif & Cantril, 1945)”.

In essence, the bulls argue that in the realm of probability distributions, given the high success ratio of monetary policy actions as reflected by the market gains in the aftermath, the probability is thus weighted to favor market gains under the present circumstances.

How valid is such claim?

Figure 3: Economagic: Reprise of 2001 “Outlier”?

The US markets went on a wild ovation in response to the US Federal Reserve’s unexpected rate cuts. On Tuesday, the Dow Jones Industrials rocketed 2.51% (335 points), the broadbased S & P 500 soared 2.92% (43.13 points) and Nasdaq flew 2.71% (70 points).

Effectively, based on the dimensions of technical readings alone, the US markets are now in bull territory, which equally delivers most global markets including the Phisix into bullish grounds.

But given such developments, should we then join bandwagon? Not so fast, I believe.

The tech bust in 2001 appears to have manifested a parallel repertoire when the FED initiated its policy changes then.

In January 3, 2001 the FED “surprised” the market as it lowered its FED FUND rates by 50 basis points to begin its “preemptive” campaign to fight deflationary forces.

The US equity markets went into fabulous hyperdrive: the Dow sprung by 300 points or 2.8%, the S & P 500 zoomed by 5% (!!) or 64.9 points and even astonishingly the Nasdaq whizzed skywards by 14.17% (!!!) or 324.83 points. Again, notice of scale of gains by the US markets then, compared to last Tuesday.

Unfortunately such burst of adrenalin wavered as the one-day gains were wiped out in the coming sessions see figure 3.

In addition, the same chart tells us that the 9/11 outlier event argument occurred when the US economy was already suffering from the throes of RECESSION (see steep fall amidst the red shadow). Hence the tragic event aggravated the already deteriorating sentiments. In other words, even WITHOUT a 9/11 the markets then was into a CYCLICAL DECLINE.

Thus, since the 9/11’s relationship was COINCIDENTAL rather than CAUSAL, writing off the 2001 equation from the probability list was unwarranted.

Nonetheless, the basic difference between 2001 and today is that the US markets sputtered immediately while today’s markets have managed to hold its gains (yet?).

Figure 4: Economagic: long term view FED Funds and S&P 500

Another basic nuance cited by the bulls lending to the supposed “increased odds” for a positive outcome entails historical precedents that have come ABSENT recessions.

In figure 4, ALL policy changes (inflection points shown by the red line) SUBSEQUENT to or DURING recessions, marked by the red shadows, saw the US markets FALL.

In other words, the defining contrast of the probability distribution, following the FED rate cuts, SHOULD BE IF A US RECESSION OCCURS OR NOT.

One should be reminded that each of the said periods had distinct or dissimilar dynamics which influenced the financial markets then. And should NOT be lumped and generalized as similar with that of today.

Whether the markets will do a rhythmical reprise of 1998 as discussed in our August 13 to 17 edition (see US Markets: Unlikely A Reprise of 1998) or that of a 2001 appears to be a 50-50 odds given the above facts.

Assigning greater odds to a positive outcome is similar to a gambler’s fallacy (wikipedia.org), ``where the random event is the throw of a die or the spin of a roulette wheel, gamblers will risk money on their belief in "a run of luck" or a mistaken understanding of "the law of averages". It often arises because a similarity between random processes is mistakenly interpreted as a predictive relationship between them.”

A gambler’s fallacy can be exemplified by coin tosses. If a coin has been flipped five times and comes up with a series of “heads”, then the usual bet for the next toss would that of a “tail” since people would be inclined to think that the “law of averages” could deliver a “tail” outcome. But this ignores the fact that coin flipping is a 50-50 odds where each “flip” is INDEPENDENT of the results of the previous tosses, hence the fallacy.

So in the present environment where the recession prospects is a RISK concern, it would appear that as the chart shows, if the US falls into a recession the market goes down while if it escapes recession it could go up. In short, a 50-50 odds.

Now when bullish commentaries tells us that the previous streaks of rate cuts ended with a positive return, we understand these as prognosis shaded with a confirmation bias. And when they introduce probabilities using the same data in support of such claims, we also understand these as forecasting based on a gambler’s fallacy.

The bullish or bearish outcome will depend on a myriad of interacting factors such as the resolution of the bottlenecks in the global credit system, the reappearance of risk taking appetite, a return of confidence to the global financial markets, the strength of the global economy, the resiliency of the heavily levered US economy, the fate of the US dollar, political risks as growing protectionist sentiment and many, many more…

US Markets: Unlikely A Reprise of 1998

``The good times of too-high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, . . . . there is a happy opportunity for ingenious mendacity.” Walter Bagehot, Lombard Street (p. 158)

Figure 6: Economagic: FED Cut case of 1998 versus 2002

The bulls argue that today’s actions has a precedent; the 1998 scenario. Then the FED applied its FIRST AID kit during the Long Term Capital Management (LTCM) induced liquidity crisis, where following the monetary treatment, its financial markets take off, as shown in Figure 6.

The leftmost red arrow shows of the FED cuts (red line) in response to the drop in the S&P (blue line) to our threshold levels. The S&P bottomed out in 3 months following the monetary remedy and speeded away for good.

However, this looks like apples to oranges comparison.

As seen above US economic growth (yellow green line) remained robust even during the selloff and looked unaffected. Second, US households and the global financial system were not as leveraged as it is today. Third, the source of stress came from external forces, following the 1997 Asian Financial Crisis. Russia went into a debt default which collapsed the highly geared LTCM run by two Nobel Laureates. And following the back-to-back crisis outside the US, money flows appeared to have shifted into the US markets which seems to have boosted the US dollar (green line), aside from its equity markets.

Today, the US economy has been growing below its average trend, US households have been levered to the eyeballs, the global financial system has exploded in size due to excessive leverage (the size of derivatives at $415 trillion is mind boggling enough!), global current account imbalances ballooned to record levels, and most importantly, the source of the present stress emanates from the US.

Fundamentally speaking, we don’t buy such arguments. However, we would keep an open mind and base our judgments on how the markets, especially the financial benchmarks, RESPONDS to the central bank impelled stimulus.

The bullish side critically DEPENDS on the central bank medicines to restore the present order. The bearish side is that central bank actions have always been SHORT-TERM in nature, and yet could go awry, as in the tech bust in 2000 (top red arrow). Besides, such inflationary actions usually involve longer term unintended consequences.

Finally, it is unlikely that a healing would occur soon. Even under the optimistic 1998 scenario, it took a QUARTER from peak-to-trough before a bottom was found. We are only about a month into this correction. It is too soon to tell.

Remember, NO trend goes in a straight line. There will always be massive relief rallies or bull traps within bear market cycles (refer to the Phisix 1997 chart). The latest Fed activities are likely to feed into the bullish insurgencies, but if problems continue to weigh on the financial system then eventually this would falter anew. Take such opportunities to exit instead as the risks prospects remain high.