Thursday, July 28, 2011

Bumping Against the Debt Ceiling: The Psychology of Imminent Default

When I compiled our financial sentiment indices in the mid-2000s, I never imagined I'd spend so much time looking at the "Anger" and "Trust" metrics.  Ah, how the world has changed.

FYI, hear an interview of Jason Zweig (WSJ), Tess Vigelund, and myself here on MarketPlace Money (NPR).

As you can see below, investor anger is at an 18 month high due to the debt ceiling paralysis:

Despite so much anger, we've only just begun to see fear creep into the stock market.  There has been an enormous divergence between investor sentiment (which has become exceptionally negative) and market prices (which have stayed relatively flat).

Part of the reason for flat prices is that more than 80% of the companies reporting 2Q earnings this season have beaten their analyst consensus estimates.  That's incredibly bullish.  Furthermore, there is a party going on in Silicon Valley.  Start-up tech companies are being routinely valued over $10 million, even without a working product.  It feels good to be in coastal California right now.

So now let's talk about what is likely to happen.  How this might play out assuming each side is negotiating from a sincere position (in game theory it is sometimes advantageous to "act crazy" in order to increase one's negotiating clout, as the Tea Partiers may be doing).

Psychologically speaking, here is what we are facing:
1.  A widely anticipated event with either a positive or a negative outcome
(long term, psychologically speaking, this situation is all bad, but more on that in a later post).
2.  The negative outcome is unprecedented.
3.  There is little that can be done to prepare for a negative outcome.

Unfortunately the negative outcome is also the most likely, and the debt ceiling will not be raised by August 2nd.  If this negative event occurs, there are likely to be band-aids applied - an executive order raising the debt ceiling, social security check IOUs redeemable at most banks (as California issued each of the past three years), and interest payments to bond holders that will be paid.

Yet there is a sense of foreboding and doom about the negative outcome, precisely because we don't know what it will look like.  (In fact, if you're a contractor for the State of California, you know exactly what it looks like - IOU certificates and long delays in payments).   Since we know some potential outcomes, let's discuss those to dissipate the doom.

What if there us a ratings downgrade of U.S. Treasuries to AA?
- Based on the regulations for pension funds, banks, etc... to hold AAA Tier 1 assets in part of their portfolio, there simply won't be enough liquid assets for all that money to move into.
- This would necessitate a change in the rules governing "secure" assets.  So fundamentally, very little would happen except a lot of confusion and panic in obscure derivatives markets that we haven't yet heard about.

In terms of the negotiations themselves, the psychology has played out such that neither side can back down.  If either backs down, they will lose face with their constituents.  If they both go through with the default, then they can both claim victory (of sorts).  Recall that Tea Partiers were elected to throw perfectly drinkable tea into the ocean - to cause short term pain (refuse a debt ceiling increase) for longer term gain (better fiscal management).  And we're currently seeing Obama's (necessary) second "stand" - healthcare reform was first.  See that graph of Anger above?  Anger causes people to become LESS flexible, not more. 

As a result of this angry (and very public) game of chicken, neither side can back down.  So ... missing the August 2nd deadline is quite possible.  "Default" on interest payments is unlikely, but issuance of "IOUs," an executive order based on the 14th amendment, or some other interesting stopgap measure is likely.  

So expect a downgrade eventually.  Expect a market sell-off.  Then expect a rebound in the short term after the panic.  (The panic in August will be good time to buy for the short term).  Long term we're seeing the symptom of a systemic disease - a disease of the U.S. political system that will not be cured without some type of major surgery.  Let's hope we can find a good surgeon.

Just like the past three years, it is time to park assets in safe havens - not cash or currency, but gold and revenue generating (emerging market bonds and some real estate) and inflation resistant stocks (recall QE3 should be helpful for the mini-bubbles in Silicon Valley: digital media, technology, mobile devices, etc...)

Happy (or at least not Angry) Investing!
Richard L. Peterson, M.D.

Wednesday, July 27, 2011

Welcome Back, Fear. (I'm Yer Huckleberry).

And, oh, by the way... WHAT TOOK YOU SO LONG?

For a moment there I entertained the notion that the collective human nature of the investing community had reached a higher plane of inner peace and tranquility, free from the materialistic worries that bedevil less enlightened souls.

But the investing community has not attained nirvana. They just don't know what to do.

I heard a financial news commentator ask a fair question today, "Why hasn't the market reacted to the debt ceiling crisis? Why hasn't there been a sell off?"

The unsatisfying and tautalogical response that leapt to mind was, "Nobody's sold off because... nobody's sold off."

Let me explain that better. Picture the OK Corrall scene in the movie Tombstone. (On the off chance you missed one of the best films of the last 20 years, I'll set the stage.)

It's a good old fashioned wild west showdown between the good guys and the bad guys. The fight had been coming for more than an hour's worth of movie time. Marshall Wyatt Earp has had enough. Earp and his posse draw their guns and head down to the corral to confront the marauding Clanton gang. The outlaws caught by surprise, look up and immediate reach for their guns too.

And then... nothing. Nothing but palpable tension ready to erupt in gunfire and an unbearably long staredown. Eight furious, frightened gunslingers with their fingers on their triggers looking at one another. The pressure builds and no one moves a muscle.

Then it happens.

Doc Holiday winks at Billy Clanton. Billy's face contorts with rage and....

KABOOM! Guns blazing! Bullets richocheting! Bodies flying! Total mayhem! Total AWESOME mayhem.

So where are the fireworks? Why hasn't the market reacted? It's not for a lack of emotion. It's not for a lack of understanding. It's not for what my science teacher told me is called "potential kinetic energy". (This kinetic energy has the potential of LeBron James.)

No. "The Market" hasn't sold off simply because... it hasn't.

But should the first frightened seller - of enough consequence to influence others -squeeze the trigger... it will cause another seller to do the same. Then another. And another. And then so many that the computers can't keep up.

Gunfight. Rock slide. Stampede. Sell off. Same thing.

So far, everybody's kept a cool head. The guns are in their holsters.

Which is the way we like it 'round these parts.

Peace and quiet. Law and order.

No need to get twitchy now, stranger.

Everbody relax... everybody ree-lax...


Happy Investing.

And hey... let's be careful out there.

-Dr. Frankenstocks

Frank Murtha, Ph.D.

Tuesday, July 19, 2011

What Happened to Fear?

"There are a lot of worries out there, but people aren't very worried."

No, Yogi Berra, has not been brought on board as a guest blogger.

This is just the best way to explain the strange paradox of the U.S. Equities markets in July of 2011.

There has seemingly been a daily trickle, if not stream, of negative economic news coming from countries that have great soccer teams and dreadful balance sheets (e.g., Ireland, Greece, Spain,
Portugal, Italy... to be continued).

Yet, MarketPsych's sentiment indicators show that worry/fear were actually much higher earlier in the year.

That's not to say that investors aren't emotional.

Investor sentiment is worse than it has been since 2009, yet market performance is still
going strong. This divergence is noteworthy... and strange (see below).

The red line represents Investor Sentiment since the start of 2010. The gray/green/red line represents the peformance of the S&P 500 Index.

Weird, right?

Maybe this unusual split is because fear does not appear (for a change) to be the dominant emotion.

So if fear isn't driving sentiment... what is?

Our proprietary tools (designed by Dr. Richard Peterson and available at indicate the following:

ANGER: People are ticked off at the forces behind the market, and likely still bitter about the effects of the banking crisis in '08. TARP and the political wrangling over the debt ceiling in the U.S. cetainly isn't helping assuage this feeling.

DISGUST: Disgust is often felt in reaction to things that are unclean. That's a good way of describing investors emotion. Investing just seems to be a dirtier business than it used to be. And they are revolted by it.

LACK OF TRUST: People are more cynical about the equities markets, and less likely to believe the authority figures are willing or even capable to do what they pledge.

So investors are "Mad as hell"... but will they "take it anymore"?

So far, the answer is, "yes".

But doing so appears to have created a great deal of emotional tension.

Happy Investing.

And hey... let's be careful out there.

-Dr. Frankenstocks