UNDERSTANDING IRRATIONAL EXPECTATIONS

11 January 2012 by Cullen Roche

In this morning’s note David Rosenberg asked an interesting question – what are the bulls seeing? Recent economic data has been good, but it hasn’t been off the charts by any means. But the market seems to have this impervious floor underneath it again. We’ve seen this a lot over the last few years and I think the underlying cause is a relatively simplistic, but often overlooked effect that occurs in markets.

Markets are based largely on forward looking irrational expectations. They’re irrational because the summation of the decisions of the market’s participants are irrational. Human beings just aren’t built for life in the markets. We are built to survive. That’s why controlling your emotions is the #1 hurdle in the markets. Contrarians try to overcome this hurdle by taking the other side of the mainstream perspective, but being a contrarian is easier said than done. I always like to say that once you can eliminate your own brain from an investment strategy that you’ve won the investing war.

Fight or flight? Harvard physiologist Walter Cannon discovered the fight or flight response in 1915. This is an innate and very primitive reaction that occurs in humans when under stress. Interestingly, what happens in such a scenario is a near transformation of our thinking. Our thinking changes from a broad focus to a narrow focus. Fear takes over our mind. Everything is a potential threat to our survival. We are quick to respond and often inefficient to respond. And more often than not, it is easier to flight than fight. We don’t stay and fight the bear when it attacks (even though studies show that fighting or rather standing up to the bear is the more likely survival technique). We run. It’s innate. It’s a survive first mentality. And it’s often self destructive. In the markets, we are often slow to react. We will actually stay and fight the bear and then run when it’s too late (if you’ve been around long enough you’ve sold at the bottom – I know I have).

The key point to understand in a highly volatile environment such as the current one is that irrational expectations are constantly shaping our expectations of the future. They are based on an unknowable and unpredictable future, but we place the bets nevertheless. So we run from the bear for 10 minutes. Then we stop and look around, are comforted by the fact that we can’t see him (he can smell you though!) and we get complacent for 30 minutes. Then the bear reappears, we panic, run, rinse, wash, repeat. It’s an endless cycle in the markets that will never end (except some people get caught by the bear!). The key to understanding market movements is understanding this dynamic of irrational expectations.

Right now, the bear is nowhere in sight. But who knows where the next bear will come from? He could reappear in the form of the Euro crisis, earnings disappointments, or some other unforeseen event. But the key is understanding why the bulls are seeing what they’re seeing because in fact, it’s not what they’re seeing that has them buying, but what they’re NOT seeing….