Mind Of The Market - I : Pavlovian Conditioning, Paradoxes & The Psychology Of Herding

In what should evolve into a multi-part series, Mind of the Market will endeavour to peer under the hood of the largest laboratory of human psychology in the world; the financial markets. Where frigid numbers and emotive participants spar enthusiastically in an elaborate and often bewildering drama-in-motion. Where apparitions and reality merge so finely as to be mostly indistinguishable. Where paradoxes and circular relationships reign supreme, frequently, and fervently, questioning the very essence of rationality and cause-and-effect.

Part I addresses the dynamics of Pavlovian Conditioning and market participant response to stimuli in investment decision-making. Intriguing paradoxes and the behaviour of asset prices - a cause (and consequence) of market participant response - is considered concomitantly. Finally, the psychology of herding closes Part I.

Pavlovian Conditioning and Asset Price Behaviour

When Ivan Pavlov discovered his lasting contribution to humanity - Classical Conditioning experiment on dogs - humankind was probably offering years of daily corroboration of the phenomena of Conditioning. An excerpt of the key theme of his study:

Conditioning is usually done by pairing the two stimuli, as in Pavlov’s classic experiments. Pavlov presented dogs with a ringing bell followed by food. The food elicited salivation, and after repeated bell-food pairings the bell also caused the dogs to salivate.

The table below broadly aggregates typical market participant response to event stimuli (information, emotional state and expectations):

Equities and commodities chime along lock-in-step, while sovereign credits adorn the character of a recession/bad news asset class ('safe' havens). Gold appears a near all-weather choice that is spurned during good times. The broad matrix, by no means sacrosanct, reasonably captures market participant psychology to macro stimuli.

Some Intriguing Paradoxes 

The Psychology Of Buying - Sovereign Credit

Mountain of Debt + New Debt = Increasing Debts-appeal

Amidst the ebb and flow of the financial crisis, new debt issued by USA, with a burden already as big as its GDP (and rising), has found enthusiastic buyers. Over the past two decades and change years, US’ debt grew 6-fold even as GDP grew 3-fold. Debt is now nearly 100% of GDP versus 50% in 1987. Back in 1987, US 10-year Treasury yielded 9.5% and inflation (CPI) was 4.5%, for a real return of +5%. Cut to the present, US 10-year Treasury yields were close to multi-century lows (c.1.5%) recently, while inflation (CPI) was c.2.5%, for a real return of -1.0%. 

Despite mounting debt burden and negative real yields, market participants gravitated towards US Treasuries. Negative real yields can be somewhat tolerated if there is a reasonable chance of greater depreciation in the currency of the marginal foreign buyer (if, say, a foreign investor makes (!) -1% by way of real yield and the US$ appreciates 6% relative to her currency, she would make 5%). 

Foreigners added ~$650 billion to their US Treasury holdings between Mar-11 and Mar-12 for negative real yields and since they hold close to half of US Public Debt ($11 trillion Public Debt, $15.7 trillion Total Debt, at last count), it is instructive to enter the mind of a foreign buyer, to discern their thinking.

Foreign holders of US Treasuries are exposed to risks on two fronts, (a) asset risk (risk of principal repayment and negative real yield) and (b) currency risk (US$ depreciation). The two largest foreign holders of US Treasuries - China and Japan - suffer from low/no real coupon and a gaping abyss if and when the US$ depreciates relative to their currencies (ignoring US insolveny risk, to keep things sane). The JPY is already feeling the heat thanks to JPY appreciation; while the Yuan, owing to the managed peg, has managed to stave off the eventuality, for now. But a gradual appreciation looks likely, for various reasons, and were it to materialise, these foreign buyers will be minus some big notes from their Treasury chests.

In the past, at the first signs of 'risk', the JPY, CHF, Gold and sovereign credits found many seeking shelter. In a vastly changed world today, similar protection is being sought. Ironically, in the shelter with the weakest foundation.

Classic Pavlovian Reaction overlaying rationality.

The Psychology Of Selling - Equities

Beneath the macro stimuli lie camouflaged several layers of micro stimuli that impinge on participant emotions and asset prices. Daily/Weekly/Monthly economic data releases, quarterly earnings reports and a host of other information trigger Pavlovian Responses in market participants; who, akin to Pavlov's mongrels that were befuddled by cause and effect; cause gyrations in asset prices bearing little relevance to actual intensity of the stimulus.

A quarterly earnings report below expectations often triggers selling in the company stock, even if the quarterly timescale bears little relevance, either to the longer timescale, or to the long-term dynamics of the underlying business. Among the higher order reactions to this earnings miss might be sympathy selling of companies in the same business (extrapolation of the reasons behind Company X's woes to Company Y), and a bump up in price gyrations.

Fed with data minutiae, often by the minute, market participants feel a compelling urge to act out (disseminate) incoming information. A quarterly GDP growth, or a quarterly earnings, print coming above/below market expectations gnaws at participants, and sightings of their emotional response can be found in the behaviour of prices. That these numbers, highly questionable in some markets, and subject to ex-post revisions, trigger multi-order reactions is intriguing. 

Instances of Pavlovian Reactions often trouncing rationality.

The Psychology Of Multiple Personality Disorder - Gold

For a wonderfully insightful example of rapidly altering human risk perceptions, it is illuminating to cast some light on the behaviour of Gold over 2011. Grave signs of multiple personality disorder was witnessed in Gold, which was one of the few asset classes that closed the year on a celebratory note.

1H 2011: Gold rose as sovereign debt worries escalated

2H 2011: Gold fell as sovereign debt worries escalated…further 

Even as fear escalated over August through December 2011 on resurgence of EU sovereign crisis, Gold suddenly seemed to have fallen out of favour. What was being hoarded on the premise of fear was now being sold, when the same reasons were available in greater supply.

 

It was roughly a year in two halves for the Yellow Metal. The first half, where it held allure to market participants as an inflation hedge/doomsday investment; while in the second half, this relationship broke down as Gold began tracking market expectations of Central Bank Quantitative Easing (a.k.a money printing).

At some point in the flowing continuum of emotional reactions, perceptions tipped; the stimuli had changed. Expectations of, or the absence of, quantitative easing began guiding market participant perceptions towards the yellow metal. As expectations for further rounds waned, so did interest in Gold. Recently, possible reopening of monetary spigots instilled some vigour in Gold.

The Psychology Of Herding

From being conditioned to dive into the seemingly soothing arms of sovereign bonds in time of duress, to selling earnings misses (and buying earnings beats) in equities, to flipping commodities on the near-term prospects of economies; herding represents one of the most innate characteristics in market participants inhabiting the financial landscape.

Being social animals, the evolutionary urge for tacit acceptance by the majority is a compellingly strong force. Apart from acceptance, the social fallout of being in the wrong while in minority further assists in the building of crowds. The prospect of quick profits while chugging along with the many instills a sense of comfort. Pavlovian Responses are, sometimes, a necessary appendage in this scheme of things.

Trend-followers, algorithms or otherwise, attuned to picking up these developments seek to exploit the power of the herd, before everybody else. Being alone, as a trend-follower, is a wondrously alluring prospect but, unfortunately, a mutually exclusive possibility. The trend follower, additionally, is an implicit Long on the persistence of the prevailing bias.

The enthusiastic herding into sovereign credit today, as a reaction to fear, has driven real yields in several geographies into negative territory. A few years down the line, when the world appears a little different from today, where interest rates would have likely ticked up from today's historically low levels; a host of market participants might awaken to the true meaning of the word 'safety'. 

Another typical Pavlovian Response in the face of catastrophe would be likely at this point - denial.

…Thus, at the court, both great and small
Behave alike, for all ape all.

– Jonathan Swift, Excerpt from The Logicians Refuted