Related topics: stocks, stock market, economy, technology, Anthony Mirhaydari
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.
We're susceptible to all kinds of biases, stereotypes and other 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.
Anthony Mirhaydari
How else can you explain the fact that investors in short-term Treasury bills are happily accepting negative inflation-adjusted returns? Or that U.S. businesses are letting their machinery rust away, sitting on money instead of paying for basic maintenance? Or the rare disconnect that's developed between bond yields and corporate earnings?
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 herd
The 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.
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.
With solid fundamentals, the most intriguing evidence of a pessimism bubble comes from what's happening in the markets.
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.
