On the Clueless Crowd

Alfred E. Neuman

Numbnuts (nuhm-nuhts) Noun 1. The stupidest of the stupid. A complete dumbass, one whose intelligence quotient does not surpass that of the average rock.
–Urban Dictionary

Empiricists will say we don’t have to explain a cyclical event. It’s enough to observe the regular recurrence of a phenomenon to use it as a guidepost for what comes next. Still, it’s nice to be given an explanation for why investors always signal tops in the market by behaving like cretins.

I’ve held that investing is an unnatural act, that most people will lose over time. Cambridge University research fellow, John Coates’ studies on the behavior of traders through market cycles bears this out. It is applicable to investors because investing is trading with a longer time frame.

Turns out, it’s body parts, not brains that cause people to disregard the obvious risk when the market is expensive. Seriously. Riffing on the science of stress, Coates notes that the brain’s primary function in stressful situations is to plan and execute movement, that every piece of information we take in, every thought we think, comes coupled with it some pattern of physical arousal.

Stress, he suggests, is misnamed because humans have stress of all kinds, much of it not very stressful. Many situations are actually a healthy part of our lives, which, in moderate amounts are enjoyable. He says, When you walk into the coffee room at work, your muscles need fuel, so the stress hormones adrenaline and cortisol recruit glucose from your liver and muscles; you need oxygen to burn this fuel, so your breathing increases ever so slightly; and you need to deliver this fuel and oxygen to cells throughout your body, so your heart gently speeds up and blood pressure increases. This suite of physical reactions forms the core of the stress response.

Coates argues our reaction to stress should more accurately be called the challenge response, particularly when risk taking is the stressor. Most models in economics and finance assume that risk preferences are a stable trait. When opening an account for a new client, financial advisors routinely ask the client to state their risk preference. The client doesn’t know it, but the correct answer is “it depends.”

After a bear market, most investors will reply that they are risk averse. A rise in volatility, along with rising prices signals opportunity. When opportunities abound, a potent cocktail of dopamine and testosterone encourages us to expand our risk taking and the investor’s  body is aroused with a rush of adrenaline and rise in cortisol levels. Periodic shakeouts, the result of lingering doubts about the durability of the upmove, generate spikes of additional cortisol, which induces caution and a reduction in the appetite for risk. The see-sawing cortisol levels even out as the market continues up. In a long bull market, a sustained level of the stuff induces high confidence, increasing the investor’s comfort with his portfolio.

Late in the bull market, volatility subsides and the investor’s physical challenge response lapses into complacency, and an inclination for some to overinvest. This is the setup for the downturn.

The absence of buying eventually leads to selling. The new challenge response is another rise in the body’s cortisol levels. This generates caution, a refrain from investing, some selling, perhaps. The continuation of the decline induces more cortisol, hyper-caution, urgent selling and, finally, panic liquidation. At the bottom, the physical response is so intense it causes the investor to freeze up completely-precisely at the time the opportunities are the greatest.

Humans respond to stress with physical arousal, not pure thought. At tops and bottoms, the most critical times in the investment cycle, their bodies sabotage their objectives. They become unwitting numbnuts.

Every metric in the human behavior spectrum is now signaling a top, in character if not in time. It matters not if the market holds up another week, or month, or even year. The next important move is baked into the situation: a horrific bear market that, based on the Elliott Wave forecast, destroys all of the gains since at least 1980.

At last count there were 51 million people with 401k accounts. Most are heavily invested in stocks. Add to that, thousands of similarly invested professional money managers of state and local pensions funds, and college, church and hospital endowments. At this point, everyone who is fully invested has the same physical response to their market position. This is one hell of a lot of numbnuts cluelessly hanging out for the slaughter. I can’t think of a more dangerous period in our financial history.

There are two certainties about a period like this: 1) Somebody, an expert of some kind and a certifiable numbnut will say ,”This time is different,” and 2) It won’t be.

Cheers,

Rod

No one should consider any part of this presentation as a recommendation to buy or sell any securities whatsoever.

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