“The year 1915 was fated to be disastrous to the cause of the Allies and to the whole world. By the mistakes of this year the opportunity was lost of confining the conflagration within limits which though enormous were not uncontrolled. Thereafter the fire roared on till it burnt itself out. Thereafter events passed very largely outside the scope of conscious choice. Governments and individuals conformed to the rhythm of the tragedy, and swayed and staggered forward in helpless violence, slaughtering and squandering on ever-increasing scales, till injuries were wrought to the structure of human society which a century will not efface, and which may conceivably prove fatal to the present civilization.” – Winston S. Churchill – The World Crisis: 1915
After reading that quote several times, it remains shocking that the politicians and individuals of that era unconsciously “conformed to the rhythm of the tragedy.” The paragraph above from Winston Churchill, describes the mass mindset of World War I when it was still in its infancy. War-time narratives, nationalism, destruction and the tremendous loss of life led most people to quickly accept and acclimate to an event that was beyond atrocious. Amazingly, less than a year before the period Churchill discusses, the same people likely would have thought that acceptance of such a calamity would be beyond comprehension.
Wars and markets are obviously on two different planes, and we want to make it clear the purpose of this article is not to compare the evils of war to financial markets. That said, we must recognize that quick acceptance of abnormal circumstances, as Churchill describes, is a trait that we all possess. The implausible, the absurd, and the extraordinary can quickly become the norm. Assumingly, this coping mechanism enables us to retain our sanity when events are far from normal.
The Fog of Markets
The seemingly unabated march upwards in stock prices occurring over the last eight years has had a mind-numbing effect on investors. The relentless grind higher is backed by weak fundamentals providing little to no justification for elevated prices. Indeed, if there was no justification for such valuations during the economically superior timeframe of the late 1990’s, how does coherent logic rationalize current circumstances? For example, feeble economic growth, stagnating corporate earnings, unstable levels of debt, income and wage inequality and a host of other economic ills typically do not command a steep premium and so little regard for risk. This time, however, is different, and investors have turned a blind eye to such inconvenient facts and instead bank on a rosy future. Thus far, they have been rewarded. But as is so often the case with superficial gratification, the rewards are very likely to prove fleeting and what’s left behind will be deep regret.
Despite our education and experience which teach the many aspects of the discipline of prudent investing, investors are still prone to become victims of the philosophy and psychology of the world around them. These lapses, where popular opinion-based investment decisions crowd out the sound logic and rationale for prudence and discipline, eventually carry a destructively high price.
Investors, actually the entire population, have become mesmerized by the system as altered and put forth by the central bankers. We have somehow become accustomed to believe that debt-enabling low interest rates make even more debt acceptable. Ever higher valuations of assets are justifiable on the false premise of a manufactured and artificial economic construct.
From Winston Churchill, we move to John Hussman of Hussman Funds. The following quote discusses the mindset permeating the stock market:
“Investors and even financial professionals rarely recognize asset bubbles while they are in progress. As the price of a financial asset rises, investors have an increasing tendency to use the past returns and the past trajectory of the asset as the basis for their future return expectations. The more extended the advance, and the higher valuations become, the more stable and promising the investment can appear to be, when judged through the rear-view mirror. That extrapolation was at the root of the tech bubble that ended in 2000, and the mortgage bubble that ended in 2007. It is also at the root of the very mature bubble that has again been established today. -John Hussman Weekly Market Commentary February 6, 2017
Presently, the Trump administration is under increasing levels of scrutiny of a variety of forms; falling probabilities of meaningful tax reform, deep uncertainty around healthcare reform, delays and question marks surrounding infrastructure spending as well as possible pre-election dealings with Russia including potential perjury charges for some campaign staffers and other administration officials. Furthermore, Janet Yellen, Chairman of the Federal Reserve, appears uncharacteristically determined to maintain a path of higher interest rate and has recently discussed the possibility of reducing the Fed’s balance sheet.
These events should cause concern for investors. The recent run-up in valuations is based on a belief that the new administration will pass pro-growth legislation. Conversely, expanding valuations of the last eight years have been on the back of extremely accommodative monetary policy. Despite the threats to both factors, one presented by a Trump administration that is on the defensive and the other, a Fed looking to raise rates sooner, the equity market remains higher still. Muscle memory has taken over and investors do not show the slightest concern for risk. Per Hussman, “investors are accepting this current bull market with increasing dedication.”
As history demonstrates, conformity to the irrational can and often does persist beyond conceivable limits yet incoherence of behavior is not sustainable indefinitely. Sanity, reality and a large dose of fear will eventually reassert themselves and force the market to adjust to appropriate levels. Interestingly, when prices finally do adjust and valuations promise generous returns, investors will find themselves caught up in the “rhythm of the tragedy” and believe that prices are only going lower.
It is difficult to maintain convictions that run counter to most investors and the tape. Animal spirits and the siren song of faulty popular logic effectively draw investors in as events pass “largely outside the scope of conscious choice”. Yet, rationality will prevail as it always has throughout human history and those on the right side of it will be rewarded appropriately.
Michael Lebowitz, CFA is an Investment Analyst and Portfolio Manager for RIA Advisors. specializing in macroeconomic research, valuations, asset allocation, and risk management. RIA Contributing Editor and Research Director. CFA is an Investment Analyst and Portfolio Manager; Co-founder of 720 Global Research.