| Pollyanna Paradox |
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| Written by Matt Blackman | |
| Monday, 19 January 2009 | |
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The Pollyanna Paradox… A financial trap that catches millions – is it avoidable? By Matt Blackman As long-time TSG weekly readers know, we have often railed against television talking-heads, fundamental analysts, politicians and bureaucrats for their inability to recognize or acknowledge the bubbles that formed from 2002-2006 even though there was significant evidence for concern. Shouldn’t these so-called experts have had some sort of inkling that there was trouble on the horizon before it hit us like a speeding10-ton semi? But the challenge has not been limited to a denial that a problem existed before the collapse. Throughout the corrections and bear market over the last fifteen months, every time stock prices stopped falling, these experts could be heard on the business networks proclaiming that now was the time to buy. We have discussed the fact in our newsletters that although these analysts sounded convincing, spouting terms like “a once in a generational time to buy” and “buying opportunity of the century” (March 2008), the market reversed again and prices continued their march lower. It has been a frustrating time to say the least, especially for investors who have been hearing similar rhetoric from their financial advisors and brokers.
Figure 1 – Historic chart of inflation-adjusted U.S. home prices with building costs, population and interest rates. Orange line on home prices marks previous bubble highs before year 2000. Chart – Robert Shiller So should those upon who we rely in the financial and economic world have seen this coming? Let’s examine the housing market, which was at the root of problem.
Home sweet test-tube “The investor’s chief problem – and even his worst enemy – is likely to be himself.” — Benjamin Graham Dr. Robert Shiller, economist and Yale economic professor and author of the book Irrational Exuberance seems to think so. Over the last two hundred years, he has demonstrated how home prices have tracked inflation – rising above the long-term average during boom periods and falling below it during recessions and depressions. In 2002 it became clear that something significant had changed. Home prices had risen well above any previous highs (see Figure 1) and that unless the traditional ratios of income and rents to home prices had been irrevocably altered, prices were not sustainable. However, prices continued rising leading many including Ben Bernanke we might add, to determine that the rules had changed. By 2006, existing home prices had risen to more than double any previous inflation-adjusted high (see Figure 1) even though incomes had not risen significantly and U.S. population growth was unchanged. But according to a vast array of experts, house prices had entered a new economic paradigm and traditional metrics were no longer valid. This idea became the new “conventional wisdom.” Market players and economic experts alike all suffered from the same condition – they’d become the latest victims of the Pollyanna Paradox. However, it soon became clear that they’d been fooled when home prices reversed in early 2007 and then continued to fall. Unfortunately, prices still have a way to go just to get back to previous bubble highs after correcting for inflation.
Figure 2 – The anatomy of a bubble and bust. The Baltic Dry Index measures the cost of shipping dry goods around the globe. Dropping below 1750 in August 2005, the index peaked above 10,500 not once but twice in 2008 as the first bubble resulted in an echo bubble hitting an ultimate peak of 11793 in May. Then after hitting a low of 663 in mid-December 2008, the index began to recover moving back above 900 in mid-January. Real estate wasn’t the only asset class affected. A range of assets from expensive art to commodities also experienced bubbles and in every case, peak prices proved fleeting. In almost every single case and in spite of the fact that such extreme price gains had never before in history proven sustainable, the vast majority of experts denied that a bubble existed. Forecasters with foresight like Peter Schiff, Gary Shilling and David Tice who warned of the building bubbles in housing and stocks in 2005 through 2007 were routinely ridiculed by experts who towed the conventional wisdom party line (see video clips in Suggested Reading below). It was only when prices fell and losses mounted that the problem became painfully evident to all concerned. Problem was that by that time it was too late to do anything about it. That’s not the worst of it. Each time the falling asset prices firmed, pundits emerged from the media woodwork to proclaim that the worst was over. And even as the data deteriorated, calls that we had reached bottom continued to be heard from the majority of talking heads. Those who followed this advice lost their shirts. This situation has been repeated countless times since financial markets were born. So why do so many get caught each time? How can you prevent being caught in the trap?
Market rhythms and rhymes “Stock market bubbles don’t grow out of thin air. They have a solid basis in reality – but reality is distorted by a misconception. Under normal conditions misconceptions are self-correcting, and the markets tend toward some kind of equilibrium. Occasionally, a misconception is reinforced by a trend prevailing in reality, and that is when a boom-bust process gets under way. Eventually the gap between reality and its false interpretation becomes unsustainable, and the bubble bursts.” — George Soros The study of booms and busts and what causes them is not new. In the aftermath of each major bubble throughout history, reams of books have been written about how and where investors went wrong. Much analysis has been published about the biggest bubble and bust (to present day) in the last 120 years – the late 1920s and the Great Depression. But whether it was the 1929 stock market peak, Dutch Tulip Bubble in 1636 (the price of a tulip bulb surpassed that of a luxury home of the day), the South Sea Bubble in Europe in1720 (share prices rose 843% in a 12-month period), the Mississippi Bubble this side of the Atlantic also in 1720 (stock prices soared 3500%), the Florida real estate bubble (lot value jumped from $1,700 to $300,000), or the 1989 stock and property bubble in Japan, each time a bubble formed all past lessons had been forgotten and any warnings from those few, who tried to warn of the impending crash, went unheeded by the masses. The Pollyanna Paradox is a name designated to describe this phenomenon by yours truly. Where did the name come from? A paradox is defined as a tenet (belief or doctrine) contrary to received opinion or common sense in the Merriam Webster dictionary. Pollyanna was a heroine in the novel of the same name written in 1913 by Eleanor Porter who was imbued by the author with an irrepressible optimism and tendency to find the good in everything and everyone. There are three main components of the Pollyanna Paradox; 1) First and foremost, it is the tendency to follow the crowd and keep buying into a bubble while ignoring the fact that prices have become unsustainable. How do you recognize a Pollyanna Paradox? When you hear people from a broad cross-section of job descriptions bragging at cocktail parties about how much money they have made in stocks or real estate for example, look out. It is a sure sign of a building bubble. The Pollyanna Paradox is the reason that Ponzi schemes will never be eliminated. Introduce a situation in which fast profits are made with minimum perceived risk where the masses can participate and you have the makings of a bubble whether it occurs in legal markets or illegal scams. 2) It also describes the uncontrollable compulsion of Perennial Pollyannas, who are labeled experts by the conventional wisdom of the day, to call bottoms in a bear market each time prices temporarily recover in the inevitable bear market that follows each and every bubble. Perennial Pollyannas are plentiful at the early stages in bear markets but their numbers dwindle as the bear market matures. There is little doubt that when it comes to markets, hope springs eternal no matter how dire the situation or evidence to the contrary may be. In a bubble, Perennial Pollyannas tell you that even though prices are at or near all time highs, “this time is different.” Soaring prices become the new “conventional wisdom,” and is adopted and even promoted by experts at all levels of government and the private sector. This attitude is supported and therefore promoted by the financial regulatory and legal system. As the name implies, a Perennial Pollyanna is an individual or organization that no matter what is happening in markets or the economy, preach that there has never been a better time to buy whether it be stocks, property, art, baseball cards or whatever is perceived to have the potential to appreciate in value at the time. 3) Finally, a Pollyanna Paradox describes the tendency to do more of what got us into trouble in the first place to solve the problem. Let me explain. All bubbles have the same cause at their root and that is the availability of easy credit and/or cheap money. So what did bureaucrats and politicians propose to resolve the credit crisis? Throw more money around and make money even cheaper by lowering interest rates. Solving a problem by doing the same things that created it has never worked before and won’t work again. But memories are short and past lessons quickly forgotten. Albert Einstein said it best when he defined insanity as the tendency to do the same thing over and over again and expect a different result.
Bubble breakdown “People change when they join crowds. They become more credulous and impulsive, anxiously search for a leader, and react to emotions instead of using their intellect. An individual who becomes involved in a group becomes less capable of thinking for himself.” — Alexander Elder In October 2007, Bespoke Investment Group compared the scope and duration of the NASDAQ (Internet) bubble with those of the Homebuilders and Shanghai Composite. At the time they had been asked by a reader how the first two compared with the last which was up more than 500% from its start in July 2005 (see Figure 3). It is interesting to note that although Bespoke could not have known it at the time, the Shanghai Composite had just hit its peak of 6124.04 on October 16, 2007 two weeks before the chart below was published.
Figure 3 – Comparison of three bubbles to October 2007 by Bespoke Investment Group. Over the next year, the Shanghai Comp would fall 1664.92, a drop of more than 72%, confirming it as a bubble. So how did Bespoke know it was a bubble at the time? Nothing in economics is certain but if it walks like a duck and talks like a duck… In other words, any asset that appreciates dramatically in a relatively short time period is probably a bubble. But what was perhaps more revealing was a comparison of the dynamics of these bubbles and the timing of each. The NASDAQ bubble began June 24, 1996 and peaked March 10, 2000. The S&P1500 Homebuilders bubble began to form March 14, 2000 just four days after the peak in the NASDAQ. Homebuilders peaked on July 20, 2005, just nine days after the Shanghai Composite market began its meteoric rise (July 11, 2005). Is it a coincidence that new bubbles formed at nearly the exact time that the previous ones were topping out?
Figure 4 – Weekly chart of 30-year Treasury bonds shows the recent price spike to the highest in history as interest rates have dropped to all-time lows. Chart by GenesisFT.com It is interesting to note that a few astute observers have commented on the fact that a Treasury bond bubble is now occurring. As we see from the next chart, 30-year Treasuries recently hit an all time high in December 2008 as interest rates dropped to their lowest levels in history amid recession concerns. As you can see from Figure 4, the Treasury bubble began to form in June 2007, just six months after housing prices started to decline.
Playing against a stacked deck “Major speculative bubbles, as I argued in Irrational Exuberance, are always supported by some superficially-plausible popular theory that justifies them, and that is widely viewed as having sanction from some authority figures. These may be called new-era theories.” — Robert Shiller (2001) In May 2001, Robert Shiller published a prescient paper entitled Bubbles, Human Judgment, and Expert Opinion in which he discussed some interesting facts at the root of the cause of bubbles. One major reason so many investors fall prey to bubbles he believes, is the requirement for fiduciaries (like stock brokers, analysts and advisors) to chart a course of action in accordance with conventional wisdom rather than his or her own judgment. “Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. With such a confusion of factors, it is hard for anyone to make objective judgments without being influenced by the recent success behavior of the market and the recent success of investments. In making major allocation decisions, one almost inevitably winds up trusting to a common or consensus view about the future. Professionals ultimately must end up generally assuming that what their colleagues believe is true.” According to Shiller, the requirement that fiduciaries follow conventional wisdom (the crowd) is mandated by law in the prudent person standard which he says has a “very long history in common law” and is “enshrined for pension funds in the Employee Retirement Income Security Act (ERISA) of 1974. This act states that investments must be made with “the care, skill, prudence and diligence, under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” In other words, if a disagreement was to arise between a client and his financial advisor because the advisor lost money, the advisor would be safe if he followed the crowd but guilty if he acted on his own judgment. The clear paradox here is that in bubbles and at key market turning points, conventional wisdom is generally wrong. Following the crowd at such times is the best way to lose money. But this course of action is required by law! It goes a long way in explaining why roughly 85% of financial advisors and brokers underperform a simple index like the S&P500 or Dow in good market or bad and why so much money has been lost in the last year. This legal framework creates a powerful incentive against acting outside the box and taking the chance of investing against conventional wisdom of the times. And that’s not the only legal challenge facing the average investor. In his excellent book Invest by Knowing What Stocks to Buy and What Stocks to Sell by Charlie Kirkpatrick CMT, the author discusses how the goals of the average investor are at odds with that of his advisor. One major conflict is the fact that brokers charge commissions and fees for managing your money and therefore make money whether or not you do. They are prohibited from charging you based on the profitability of your investments under the Investment Act of 1940, according to Kirkpatrick. This is one major reason for the birth of the hedge fund industry which enabled money managers to act more like partners with their clients, making money when their client did and losing their fees when the account lost money. Unfortunately only sophisticated investors with invest-able assets in excess of $1 million dollars or more qualify for this type of service, leaving the average investor vulnerable to the trials and tribulations of the Pollyanna Paradox.
Practicing paradox prevention “Wishful thinking bias appears to play a role in the propagation of a speculative bubble.” — Robert Shiller Bubbles occur for a number of reasons, the most important of which is easy credit. They are fueled by one factor and that is greed and it is this avarice that makes these phenomena so hard to prevent. Like sharks in the wild sensing blood in the water, once profits start to accumulate, investors are magnetically drawn and in the process check their capacity for critical thinking and evaluation at the door. It is only when the money evaporates and losses mount that the fiscal feeding frenzy comes to an end. And the longer it lasts, the more painful and protracted the aftermath. Over the years, politicians have struggled to prevent these manias with rafts of new regulation – but it is this regulation that in many ways has become counterproductive and put the very people it was intended to help at distinct disadvantage. For those with a goal of achieving financial independence at some points in their lives, it is essential to avoid the pitfalls and traps that ensnare the average investor. This means they must fight the internal and external urges to follow the crowd and avoid conventional wisdom no matter how right it may feel at the time. It also means steering clear of those financial fiduciaries and advice providers who belong to the conventional wisdom club. To ultimately survive, it is also essential that you become aware of the signs of a bubble and avoid them at all costs. You will probably leave profits on the table but will also avoid the painful and debilitating financial collapse that follows along with those who were either too short-sighted or greedy to avoid entrapment in the Pollyanna Paradox. Invest by Knowing What Stocks to Buy and What Stocks to Sell Charles D. Kirkpatrick II, CMT, 2009, Pearson Education, FT Press http://www.charleskirkpatrick.com/publications.html Bubbles, Human Judgment, and Expert Opinion – Robert Shiller http://papers.ssrn.com/sol3/papers.cfm?abstract_id=275515 South Sea Bubble (1720) http://www.stern.nyu.edu/eco/seminars/FinHist/Southseabubble.pdf Mississippi Bubble (1720) http://www.britannica.com/EBchecked/topic/385600/Mississippi-Bubble Florida Real Estate Bubble (1920s) http://floridahistory.org/landboom.htm Trader6.com Quotes on bubbles http://trader6.wordpress.com/add-or-update-your-own-quote/bubbles-manias/ The Complete Edition of Murphy’s Laws http://matija.monitor.hr/murphy/0001567/download/edition.htm Videos Peter Schiff versus the Pollyanna gang 2006-7 http://www.youtube.com/watch?v=zz_yw0kq3MM Peter Schiff December 22, 2008 http://www.youtube.com/watch?v=ZHq-D-ya0go&feature=related Peter Schiff on the auto company and government bailouts December 2008 http://www.youtube.com/watch?v=XXpzMw-e01g&NR=1 What is Peter Schiff saying now? Jan 7/09 http://www.youtube.com/watch?v=9h2x7R8pxUs --------------------------------------------------------------------------------------------------------------------- If you find this newsletter insightful, please feel free to forward this newsletter and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be have it sent to them each week). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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