Sentiment Speaks: You Are All Fooling Yourselves

Last week, I wrote an article entitled “Reasons For A Crash.” And, I will let you in on a little secret – I actually wrote that title as a test. You see, I assumed that the great majority of those who clicked to read the article would do so because they expected that I would provide fundamental “reasons” as to why I think we are going to crash. The great majority of you believe in fundamental reasons driving our market because you believe that if you can understand the “reason” as to why a market moves in a certain direction, then you have a certain amount of control over the market. But I have another secret for you: Such a perspective is pure folly. It’s an illusion. No one can control the market. Moreover, the market is not a “reasonable” environment. Has any investor ever used a logician in their market analysis? The reason is because logic and reason do not drive the market. Rather, the market is an emotional environment. To apply reason to the stock market environment would be akin to reasoning with your spouse when they are being emotional. How well has that worked for you? Are you starting to understand why most of what you are seeking in the market will never be attained with the methods currently utilized by most? You are trying to fit a square peg into a round hole. But have you ever really considered why? Much of your perspectives are based on some form of fundamental analysis centered around economic theory. Yet, have you ever considered whether economics and the stock market are different environments? Well, consider that an underlying assumption within economics is ceteris paribus (all other things being equal), and the Efficient Market Hypothesis is the underlying theory supporting most of “modern” economic theory as applied to the stock market. Now, beyond the ridiculous proposition of “all other things being equal,” further consider that two underlying assumptions of the efficient market hypothesis are that all investors act rationally and that all investors act with the same knowledge, you can easily understand why these ivory tower theories are simply unworkable in the real world of financial markets. Therefore, we must come to accept and actually internalize that it’s unworkable to apply analysis based on economics in the forum of finance. In fact, it has been an abject failure at the times when it was most needed. After the analyst community failed to foresee the market swoon off the 2000 market top, on Oct. 6, 2002, Paul Samuelson, a co-founder of modern economics, admitted “[w]e are at a loss for words. If nothing else, this baffling economy has defeated the vocabulary of economics.” As an aside, it’s interesting to note that Samuelson’s admission came within several days before the market bottomed and began a multi-year rally into 2007. Yes, his exasperated admission wherein he effectively threw his hands up in the air in submission marked a multi-year bottom at an extreme in negative market sentiment. He was being driven by market sentiment and likely did not even realize it. But, the failures of 2000 have not stood alone. While there were many admissions of failure after the analyst community’s inability to also recognize the impending market meltdown which began in 2007, I will list a few that were cited by Bob Prechter in his seminal book The Socionomic Theory of Finance (a book which I strongly suggest to each and every investor, as it is one of the most eye-opening books ever written about the stock market). In February 2009, the Kiel Institute noted that “the global financial crisis has made clear a systemic failure of the economics profession. In our hour of greatest need, societies around the world are left to grope in the dark without a theory… The cornerstones of many models in finance and macroeconomics are rather maintained despite all the contradictory evidence discovered in the empirical research.” Also in February 2009, Paul Volker, former Fed Chairman, said regarding the economy: “It’s broken down in the face of almost all expectations and predictions. Even the experts don’t quite know what’s going on.” In May 2009, the Wharton Business School noted regarding the analyst community that “[i]t’s not just that they missed it, they positively denied that it would happen.” In the New York Times in August 2013, we read that “[t]he trouble with economics is that it lacks the most important of science’s characteristics – a record of improvement in predictive range and accuracy. In fact, when it comes to economic theory’s track record, there isn’t much predictive success to speak of at all.” And, finally, in January 2010, Eugene Fama, the father of the Efficient Market Hypothesis, told the New Yorker “I’d love to know more about what causes business cycles. I used to do macroeconomics, but I gave up long ago. Economics is not very good at explaining swings in economic activity. We don’t know what causes recessions. We’ve never known.” Yes, my friends, feel free to read that again. The father of EMH came out and told us that it does not work, and he gave it up long ago. Mr. Prechter went further as he then outlined the reasons why such analysis has been an absolute failure in chapter 15 of his book. Whereas the law of “supply and demand operates among rational valuers to produce equilibrium in the marketplace for utilitarian goods and services… [i]n finance, uncertainty about valuations by other homogeneous agents induces unconscious, non-rational herding, which follows endogenously regulated fluctuations in social mood, which in turn determine financial fluctuations. This dynamic produces non-mean reverting dynamism in financial markets, not equilibrium.” Moreover, since the efficient market hypothesis (the basis for fundamental analysis in financial markets) is an outgrowth from the world of economics, it’s pretty clear that it has become quite commonly viewed as an unworkable paradigm for financial markets (as noted above) for various reasons. So, as I read more and more about these failures, it begs the question as to why economists and market analysts still use these methods when most recognize they often fail? The answer given by many economists today is truly astounding: They simply have nothing better. Yet, Benoit Mandelbrot outright stated that one cannot reasonably apply an economic model to the financial markets:

“From the availability of the multifractal alternative, it follows that, today, economics and finance must be sharply distinguished . . .”

From an empirical standpoint, consider that, within economic theory, rising prices result in dropping demand, whereas rising prices in a financial market lead to rising demand. Yet, most continue to incorrectly apply the same analysis paradigm to both environments. As those of you who have come to know me well through the years, and understand my background of being an accounting and economics major in college, passing the CPA exam, earning my JD, going on to an LLM program, becoming a national director, and partner of a major firm where I spearheaded many large company deals, you would clearly understand that I started my investing career with fundamental analysis. Yet, I have abandoned it when analyzing the overall stock market because analyzing market sentiment has been a much more accurate lens through which to view the machinations of the stock market. And those who have followed me through the years can attest to this fact. Now, if you need further evidence beyond what I have chosen to highlight in this article, feel free to read the following recent article written by John Rekenthaler, the vice president of research for Morningstar, who outlines the abject failure of following economists when trying to outperform the stock market here. Yet, one of the points that Mr. Rekenthaler missed is that the economists announced their declaration that the market is in recession just as we were hitting the lows in March 2020. In fact, they only declared the market to have emerged from the recession several months later after the S&P500 had rallied well over 1000 points off the March 2020 low. Overall, I think his study reinforces what Eugene Fama said, which I noted above:

“I’d love to know more about what causes business cycles. I used to do macroeconomics, but I gave up long ago. Economics is not very good at explaining swings in economic activity. We don’t know what causes recessions. We’ve never known.”

So, for those new to my writings, I would like to introduce you to some new concepts in understanding market dynamics which I have outlined in the following six-part series I wrote on Seeking Alpha a number of years ago: Part-1 Part-2 Part-3 Part-4 Part-5 Part-6 For those of you willing to maintain an open mind and advance your knowledge about market dynamics, let me give you some of the encouragement offered by a member when he said that “[f]inding Avi, learning over the last four years, and implementing Elliot Wave/Fib Pinball has been life-changing for me, and it has given me the most confidence I’ve ever had in managing client accounts.” For those who are still unwilling to open their minds and choose to continue applying what has proven to be a failed endeavor throughout history, I will offer my condolences to your investing accounts based upon what I fear is coming down the road. And, for those who are willing to open their minds to the psychological aspects of the stock market, I wish you a tremendous amount of success down the path you are choosing to adopt and believe your accounts will be thoroughly enriched with your newly gained knowledge and understanding. Housekeeping Matters If you would like notifications as to when my new articles are published, please hit the button at the bottom of the page to “Follow” me. For those who are questioning why all comments (including mine) go through moderation, you can read here: Haters Are Gonna Hate – Until They Learn.