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John Hussman: Pills For Cognitive Dissonance In A Speculative Bubble
Jan. 6, 2015 11:29 AM ET
Excerpt from the Hussman Funds' Weekly Market Comment (01/05/15):
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In the 1950’s, Stanford psychologist Leon Festinger developed the theory of cognitive dissonance, describing the psychological conflict that results from holding two opposing beliefs or attitudes at the same time. When subjects were asked to convey or act on information that they knew was untrue (and were provided only weak justification for doing so), the resulting “cognitive dissonance” actually led them to change their own beliefs and attitudes to be consistent with the untrue information. It is difficult to hold opposing beliefs simultaneously. Festinger later showed that people typically respond in two ways to cognitive dissonance. Either they try to preserve their current understanding of the world by rejecting or ignoring conflicting information, or they abandon their existing beliefs to reduce the conflict.
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. We should recognize that this same narrative was observed in the late-1920’s bubble-crash, in the tech bubble-crash, in the housing bubble-crash, and will be remembered painfully, but in hindsight, as the QE bubble-crash. 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 (seeYes, 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.
For bulls, this cognitive dissonance creates the temptation to ignore the speculative risk and to dispense with valuation concerns by citing measures that have weak or zero historical relationship with actual subsequent market returns. The result is a stream of justifications for why stocks are reasonably priced and likely to advance without interruption. For bears, this cognitive dissonance creates the temptation to ignore the rising prices – to plant the valuation flag, knowing that a century of evidence on reliable valuation measures supports the strong conviction that market returns over the coming decade will be dismal (most likely negative over horizons of 8 years or less), and that the likelihood of a market loss on the order of 40%, 50% or even 60% in the next few years is quite high.
In short, the near-term outcome of speculative, overvalued markets is conditional on investor preferences toward risk-seeking or risk-aversion, and those preferences can be largely inferred from observable market internals and credit spreads. The difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes, has little to do with the level of valuation and everything to do with investor risk preferences. That, right there, is the primary lesson of our own challenging experience in recent years.
This distinction was embedded into our pre-2009 methods, but was notsufficiently captured by the ensemble methods that emerged from my ill-timed 2009 insistence on stress testing our approach against Depression-era data. We ultimately reintroduced this distinction as an overlay to those ensemble methods. We completed that terribly difficult transition from our pre-2009 methods to our present methods of classifying market return/risk profiles in June.
The impact of these adaptations may take longer to become fully apparent. In recent months, market internals and credit spreads have been deteriorating while the major indices have clawed higher, so strategies that are long a diversified portfolio of stocks and hedged with cap-weighted indices haven’t had traction. But that phenomenon is consistent with a peaking process, as the hallmark of market peaks is a subtle internal deterioration that often precedes more obvious market losses.
I can’t offer any assurance about the near-term direction of the market or even the near-term effectiveness of our own strategy. I can’t assure that market internals and credit spreads won’t improve in a way that defers our concerns about steep market losses. The one assurance that I can provide is that we’ve addressed the challenges we’ve faced since 2009 in a way that is robust to data from every market cycle we’ve observed over a century of history. Maybe future cycles will be different, but I would much rather adhere to a historically-informed, factually coherent discipline that would have effectively navigated Depression-era data, post-war data, bubble-era data – and even the period since 2009 – than to assume that the lessons of history are useless or that inconvenient facts should be discarded. If you’ve followed my work for a long time, it should be clear that the framework I’ve described provides a consistent explanation for both my greatest successes and my periodic failures.
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.”
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. In an environment where market internals and credit spreads are deteriorating, betting on risky assets is extraordinarily dangerous and subject to abrupt air-pockets, free-falls and crashes – the “sudden reassessments of market valuation” that Tenebrarum correctly recognizes. That’s what we presently observe, and it demands the red pill that makes one conscious of the painful reality of the present situation. But those conditions may change, and in that case, the immediacy of our concerns should ease accordingly.