Economists like to cast us all as logical actors who thoughtfully weigh costs, benefits and potential risks. But that's not how people actually behave.cognitive shortcuts that have developed over eons -- and that frequently trip us up in modern life.
These instincts power economic bubbles like the ones we've lived through in technology and real estate. And right now we're seeing another bubble -- in pessimism.
Most investors associate bubbles with market booms and excessive greed. But fear is arguably a more powerful emotion than greed.
And right now, as debt troubles in Europe have caused the U.S. economic recovery to slow, just when we'd started to put the banking crisis behind us, a paralyzing state of fear has taken hold of many everyday investors and corporate executives.
Like all bubbles, this one, too, will end -- and sooner rather than later. If we want to use that end to our advantage, we need to understand why fear and uncertainty have reached such unjustified levels. Let's consider first what drives bubble psychology.
Follow the herdThe study of market bubbles is in flux, but some answers are starting to emerge. They suggest that humanity's tendency to get its social cues from others -- so-called herd behavior -- is responsible. This means that risky actions, such as stretching budgets to buy homes or to buy tech stocks on margin, become contagious across an economy as we mimic the way those around us are acting.
In a recent experiment, Sheen Levine of Singapore Management University and Edward Zajac of Northwestern University found evidence to support this theory (.pdf file). Participants were given fake money to buy fake stocks. Before trading started, all learned how to properly value the "stocks" they were about to trade. But as trading progressed, prices became more and more separated from fair value. The test subjects forgot their training and focused more and more on what everyone else was doing.
Economist Douglass North, who won a Nobel Prize in 1993 for his work on the subject, notes, "We form mental models to explain and interpret the environment . . . (which) may be continually redefined with new experiences, including contacts with others' ideas."
Simply put, we can't help but observe and adopt the behavior of others. It's how our brains are wired.
The experiment by Levine and Zajac shows, on a small scale, that this dynamic plays out even in efficient, transparent markets in which investors have all the information they need to make reasoned decisions. That means that despite all the advances we've made to create a better, safer and more responsible financial system, we can still be brought down by our natural urge to follow the crowd.
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Is a bubble blowing?Understanding what drives bubble-forming behavior is one thing. It's quite another to declare that a new bubble, a pessimism-fueled bubble in bonds and other so-called safe assets, is in fact under way. We need to know whether there is too much fear relative to economic reality.
In my recent columns and blog posts, I've laid out a number of reasons to remain optimistic about the future. Although growth has slowed lately, it hasn't stopped. Recent data points, including the August manufacturing and employment reports, have come in better than expected. For now, the picture is clearly improving. I also think another bout of deflation, which has been cited as a big justification for purchasing low-yielding Treasury bonds, just won't happen.
Money is fast being pulled out of equities: According to TrimTabs Investment Research, retail investors have withdrawn nearly $50 billion from U.S. stocks this year. This exceeds the total annual outflows of 2007 and 2009. Professional investors aren't far behind, with hedge funds losing nearly $3 billion in July as assets under management sank to the lowest levels since last November.
On the other hand, money continues to flood into the bond market. So far this year, retail investors have invested nearly $223 billion in fixed-income mutual funds. And despite the 66% rebound in the S&P 500 Index ($INX) from its bear market low, retail investors continued to focus on bonds, with fixed-income funds receiving inflows of $20 billion or more in all but one month since April 2009.
These lopsided fund flows have come despite a return in corporate profits to pre-recession peaks. As a result, some strange things are happening in the relative valuation of stocks versus bonds. Normally, corporate bonds and stocks should move in lockstep, because the returns to both are tied to the financial health and future profitability of the businesses that issue them. Bonds for a long period outperformed stocks by a wide margin, because so many more people want to buy bonds.
But as you can see in the chart below, the earnings yield, or return, on the stocks in the S&P 500 Index has now moved over corporate bond yields in a big way for the first time since 1980. Remember that prices move inversely to yield, so the higher earnings yield on stocks is a reflection of stock market weakness, while the drop in bond yields reflects buying interest.
Citigroup strategist Tobias Levkovich chimes in with another indication that stock market anathema is becoming irrational. He finds that investors are discounting the future earnings potential of the U.S. stock market so severely that nearly 115% of the total value of the stock market right now is attributable to earnings simply staying at current levels. Since 1971, this reading has averaged about 70% as investors assigned a positive value to future growth prospects.
In layman's terms, investors are acting as if corporate America won't ever grow again.
Not only is this the most extended this measure has been in 40 years, but it means that future growth is being assigned a negative value. For reference, throughout the 20th century, company earnings per share grew an average of 4.8% per year. But investors now expect something much worse.
Is the end near?A number of factors suggest the pessimism bubble will soon burst.
The first factor is that long-term interest rates tend to move up and down on 60-year cycles -- a characteristic highlighted by Tom McClellan of the McClellan Market Report.
The second factor is that stocks don't tend to underperform for very long. The chart below illustrates the rolling 10-year total return to the S&P 500 Index -- which has been extended back to 1800 by the folks at Global Financial Data. The idea for the chart comes from Ned Davis Research.
As you can see, when the 10-year return goes close to zero or below it, major generational lows tend to form. These are rare events, with the most recent occurrences in the mid-1970s and the late 1930s.
You can see how many of the time frames align in these last two charts: Interest-rate lows of the 1890s and the 1940s coincided with lousy 10-year stock returns. The periods leading up to the interest-rate lows were bond bull markets, which helped pull money out of equities, just as we are seeing now.
If the pattern repeats, then interest rates will put in a low this year before heading for dramatically higher levels through 2040. And that means the bond market is headed for a multidecade bear market -- because prices fall as yields rise.
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The tax man comethThere is one more big issue that poses a threat to the bond bubble.
Should the Bush administration's tax cuts expire for the wealthiest Americans, the tax rate on investment income will spike from 15% now to 39.6%. Eventually, the tax rate on dividends and interest income will rise above 43% when the new tax to support the health care reform kicks in. In the end, all that income that investors are so obsessed with right now -- from bonds and high-dividend stocks -- could end up carrying a tax burden three times that of income from capital gains.
The obvious solution to this problem is for investors to reallocate their asset mixes back toward growth stocks and away from income-producing securities. This would weigh on bonds and dividend plays in the utility, real-estate and energy pipeline sectors. Theand exchange-traded funds would surely come under selling pressure. Stock prices overall would rise.
It's time to prepareIt wouldn't take much to reorient your portfolio to prepare for the inevitable unwind of this bubble in doom and gloom. Reduce your exposure to bonds, especially low-yield Treasury securities. And start increasing your allocation toward growth-focused stocks, especially those with exposure to the continuing rebound in business spending.
Technology and semiconductors are a good place to focus with theand . Bernstein Research analyst Toni Sacconaghi recently pointed out that tech shares are now trading at the lowest relative valuation levels to the S&P 500 seen in nearly 20 years. So shares in this area are in undervalued sectors, in an undervalued asset class, and are carrying loads of cash on the balance sheet to boot.
Of course, if you want to get fancy and bet directly against the pessimism bubble, you can use the. This is a leveraged ETF that returns three times the inverse return of Treasury bonds. So if a bond's return drops $1, this bear issue rises in value $3. Since long-term bonds are intrinsically more sensitive to changes in price, even before adding the leverage, consider this a highly speculative holding.
At the time of publication, Anthony Mirhaydari did not own shares of any company or fund mentioned in this column.