rostenko's latest - "it's all about perceptions"

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    It's All About Perception

    by Mark M. Rostenko
    Editor, The Sovereign Strategist
    February 15, 2005

    In case you haven’t noticed, the stock market hasn’t done all that much this year. After a very promising late-2004 rally petered out right from the opening bell at the first crack of 2005, we’ve mostly been working our way back to even. It hasn’t exactly been an awe-inspiring market and if January is any indication, (some say it is), the rest of the year doesn’t promise to be much better.

    We’ve talked ad nauseum about the imbalances in the market and the U.S. economy. We’ve talked about the overpricing of stocks, the record deficits, the lack of savings, the credit bubble, the trade deficit. And yet despite all of our talking, the market obviously isn’t all that convinced of the potential threats. Does the market know better?

    What is the market but the collective opinion of all its participants? It’s a big fat mishmash of public opinion, private opinion, and professional opinion. Don’t let some ivory-tower academic tell you any different: the market is simply an opinion, a psychological phenomenon, if you will, that may or may not at any given time bear any slight resemblance to financial/economic reality. It does NOT reflect economic reality. It reflects the collective perception/opinion of economic reality.

    We talk about earnings, deficits, politics, blah blah blah because that’s what humans do. We reason. We look for explanations. When there aren’t any, we make some up to feel better and more secure on this tiny, uncertain globe. But even our most reasonable reasonings ultimately come down to opinion. Case in point, today’s brilliant analyses from a major news outlet:

    “Retail Sales Are Weakest in Five Months” - Associated Press

    “Stocks Mixed Despite Strong Retail Reports” - Associated Press

    I submit to you, dear reader, that today’s collective opinion of the market is NOT (as prices would seem to indicate) that things are looking up but simply a supreme and ill-founded confidence that things can no longer go wrong. The market isn’t up because the economic/political/business outlook is particularly favorable but primarily due to the expectation that even if it isn’t favorable, there’s no longer anything to worry about, ever.

    Human beings tend to be rather myopic. “If it happened before I was born, it didn’t really happen. And even if it did, who cares?” Today the financial community is dominated by folks who never saw a long-term bear market. But more importantly, today’s financial community is the market equivalent of “the boy in the plastic bubble”, protected from all manner of ill-tidings and less-than-favorable developments by Master of the Financial Universe Alan “Bubbles” Greenspan who will see to it that nothing bad ever permeates the plastic, that the bubble will remain eternally inflated with stagnant but sterile air and plenty of liquidity.

    Complacency is running high. Bullish sentiment has edged into the stratosphere, by some measures even higher than at the peak of the bull market. Volatility is exceptionally low indicating that market participants perceive no threats, EVEN WHILE WE’RE IN THE MIDST OF THE GREATEST FINANCIAL IMBALANCES OF ALL TIME.

    Years into this so-called recovery the deficits have risen, the trade picture has deteriorated, the jobs picture hasn’t much improved, the dollar recently flirted with historical lows and inflation is on the rise. And yet complacency seems to be at an all-time high.

    Why? Because nothing bad can ever happen. The S&P 500 can get lopped in half, but as the past couple of years demonstrate, at least half of the loss will be recouped. “And if half has been recouped, then surely another half is just around the corner! And then another half!”, says the public. Hedge fund collapse? Latin American debt problems? Stock market collapse? No worries, Uncle G and his cash-spewing fire hose to the rescue.

    What if rising short-term interest rates bust the “carry trade”? No worries. Uncle Al will handle it. What if mortgage rates rise and the housing bubble deflates? No worries. Uncle Al will figure something out. If he’s handled it for as long as most folks can remember, so the reasoning goes, he’ll handle it forever and ever.

    The public has been conditioned by a many years of very favorable economic times to assume that whether it be Greenspan or his successor, someone will handle it. Someone will continue to make the problems go away. Because it’s “always” been that way. (“Always” being the apparent 20-year limit of today’s “fast-food” society.)

    We see things “handled” and conclude that things will continue to be handled, even while underneath it all, the imbalances continue to fester making the eventual reckoning all the more inevitable. Today’s financial community is like the gambler who sees the dice come up “7” three times in a row and figures that the odds of another “7” must therefore have increased because “the dice are hot.”

    In fact, the odds of “7” coming up on any given roll are exactly the same as they’ve always been, while the odds of “7” coming up four times in a row are dismally low, as they’ve always been.

    The public has been lulled into a false sense of security suggesting that every passing day without a problem increases the odds that no problem will ever occur. The more fires the Fed puts out, the better the odds that the next fire will submit to their efforts as well. They’re aware of the imbalances; they just don’t care about them anymore because if we’ve rolled “7” four times in a row, we can surely roll it five and six times in a row.

    But reality is just the opposite. Investors are betting that “7” can continue coming up indefinitely, disregarding the fact that the odds of rolling a 2, 3, 4, 5, 6, 8, 9, 10, 11, or 12 are much, much higher. The stock market is all about perception and opinion. Sorry folks but it’s NOT about fundamentals and it’s not about valuations. Every bubble, every crash in history stands as a bold testament to that fact. Value, earnings and fundamentals didn’t change much between 10/16/87 and 10/19/87 but the collective OPINION of the market sure as heck did!

    The primary reason why the market moves higher in the face of tremendous imbalance is due to the perception that the threats aren’t anything to worry about. It’s an opinion. What do you have when you have a market supported at historically high valuations by the very thin edge of an overconfident and unrealistic opinion? A recipe for a major turning point.

    That turning point will come and it will come LONG before the S&P 500 sees a new all-time high. And it will likely be precipitated by some situation, some event that tips the scales, that forces market participants to realize that they can’t overlook the obvious any longer. Psychology will shift and it will shift quickly. And you don’t want to be holding the bag when everyone heads for the exits.

    Of course, turning points always come. Eventually I’ll be right, as anyone with any viewpoint will eventually be proven right. Given enough time, the most bullish of bulls and the most bearish of bears will all have their day in the sun. Eventually I’ll be right and eventually so too will that “Dow 36,000” whackjob. As they say, even a broken clock is right twice a day. So what does all my rambling matter?

    It matters because the greater the imbalance, the longer things stay out of whack and continue to grow increasingly out of whack, the greater the eventual price that must be paid. The bigger the balloon inflates, the bigger the explosion when it pops. Being eventually right doesn’t matter in a business where timing is everything. But being aware of the tremendous risks to being long at the wrong time can make all the difference in the world.

    © 2005 Mark M. Rostenko


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