Greek Tragedy, the Predictive Power of Scandal, and Rewriting an Investing Truth
[Animal Spirits] refers also to the sense of trust we have in each other, our sense of fairness in economic dealings, and our sense of the extent of corruption and bad faith. When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people.
~ Robert Shiller, 2013 Nobel Laureate in Economics
Greek Tragedy
The question for the markets this month - will Greece default? In the media we hear a morally righteous tale that Greeks should shape up and pay back what they owe. We don't often hear the rationalizations of the Greek side - that other European banks were foolish to lend to a country with such a long history of default and unsustainable deficits. Yet, they were, and here we are.
Austerity makes the economic and psychological damage worse for Greeks, and it not only impairs the ability to repay, but it is also unnecessarily punitive. With a mandate from Greek voters to spurn the austerity program and the reticence of creditors to bend due to fears of moral hazard, the only sensible way forward is default. Greece simply cannot (and should not) pay what it putatively owes. If default happens this month, would all be lost in "Europe's Lehman moment?" Would that shattered trust lead to plummeting stock markets and interest rates and a massive global flight to safety? It has boiled down to a crisis of trust, and for that reason, it presents tremendous opportunity.
In an earlier newsletter we examined how mistrust in leadership is a contrarian predictor of stock prices. In today's newsletter we discuss shattered trust generally. Trust is more resilient than might be expected. And for investors, shattered trust presents tremendous opportunities.
A Culture of Scandal
The United States has its fair share of ethical scandals. Alongside those is often moral self-righteousness and outrage in the media. Last week we had another high-level scandal - Dennis Hastert was the Speaker of the House of Representative (America's lower body of Congress) and thus third in line for the Presidency during the years 1999-2006. Meantime he was allegedly paying "hush" money in cash to a boy he sexually abused decades prior.William Andrews Clark was caught in a bribery scandal during a campaign for the U.S. Senate - he was said to describe the Montana legislators this way: 'I never bought a man who wasn't for sale.'
~ Bill Dedman
Bill Clinton's Lewinsky cover-up involved lying under oath. Elliott Spitzer was attorney general and then governor of New York. Some thought he would become the U.S. President, but after a prostitution scandal and his resignation in 2008 (he charged his credit card for sexual liasons), public faith in him was shattered. Yet both he and Clinton returned to public life (Clinton much more successfully). Spitzer hosted a CNN television show and lectured on law at City College of New York. Clinton's wife is the lead contender for the Presidency.
Bill Clinton, Hastert, and Spitzer did what they did. Clinton and Spitzer recovered public trust to some extent - much more so for Clinton, as he is much more personable (Hastert probably will too). When we see a moral violation like those that they committed, moral righteousness often blinds us to the fact that time will pass, and they probably recover to a substantial degree. Moral righteousness may feel good, but as investors it doesn't serve us to waste mental energy on it. However some scandals present opportunity.
Corruption, Brazil, and Petrobras
Corruption scandals bring to light a darker side of human nature, and it should be no surprise that they instill a particularly damaging and persistent brand of negative sentiment among investors - mistrust. When our Trust index is low, it represents such mistrust, often fueled by scandals and criminal behavior by companies or their management.Sometimes negative news does come out, but it is often exaggerated and manipulated to spread scandal.
~ Pope Francis
Sometimes sentiment can be used as a stock screening tool, and in exploring our data with sentiment screens, we often stumble upon evolving stories. In the spring of 2015 we screened for the largest Latin American stocks by sentiment to better understand recent events in Brazil. Dilma Rouseff, Brazil’s President, was struggling at the polls due to a series of crises, and we were curious to compare her travails to those of individual companies. We compared four of the top companies in Brazil (and one from Mexico) from June 2014 through May 2015. Below is the chart of their 90-day average media sentiment - Petrobras (blue line), Vale (green line), America Movil (black line), and Brazilian Distribution Company (red line).
In this chart we noticed that Petrobras (PETR4) started the period with second to the highest sentiment, but finished it with the lowest sentiment. We traced this reversal in fortunes back to the media mentions of these companies, and we found reports of criminal activity at Petrobras.
Petrobras was subject to a major scandal involving corruption and kickbacks, implicating involvement near the top of the Brazilian government. As the weeks passed and more information came to light, it became apparent that $2 billion dollars had been funneled to pay bribes in order to secure lucrative contracts for the company. The fallout from the scandal could shave up to 1.5% off of Brazil’s GDP for the year. Considering these sobering facts we were curious to explore the price following this scandal, and what we found surprised us.
Below we see how the Trust investors expressed in Petrobras fell as the scandal gradually broke, and it continued to fall as more details of the graft emerged.
The slide in Petrobras’ stock price is no surprise. Projections of the extent of the corruption scandal grew throughout Fall 2014, and the stock slid along with each new revelation. Further it’s no surprise that the scandal would cost Brazil’s GDP, as interpersonal trust in a country is a known predictor of economic activity. Researchers have found that countries with lower levels of interpersonal trust have slower economic growth. Conversely, increasing levels of trust predict greater economic activity. Interestingly, the mechanism by which trust increases growth is very long-term in nature: “[T]rust affects schooling and the rule of law directly. These variables in turn affect the investment rate (schooling) and provide a direct effect (rule of law) on the growth rate.” The Petrobras scandal may have far-reaching implications for Brazil’s economy, and as a result, investors are not irrational to clear out of their Petrobras investment…or are they?
If we do not trust a company or its leadership team, then not only we are unlikely to invest in its stock, but we may also make rash, impulsive decisions with our current investment in it. That is, we may hold our loser too long, and ultimately sell impulsively, capitulating, often near the market bottom.“There are good times when people have substantial trust and associated feelings that contribute to an environment of confidence. They make decisions spontaneously. They believe instinctively that they will be successful, and they suspend their suspicions. As long as large groups of people remain trusting, people's somewhat rash, impulsive decision-making is not discovered.”
Investors often overreact to events with vivid, potentially catastrophic consequences, regardless of the actual probability of the negative outcome. Investors underprice assets in which they have lost faith. Yet they lose faith too soon. Based on our CJ Liu’s research, trust is a key indicator of stock price overreaction. In the case of Petrobras, the stock’s 75% rally over the two months from March to May 2015 (visible in Figure 2), should not have been wholly unexpected.
The Trust Factor
As Dr. Shiller suggests, trust is a key “animal spirit,” and its effect on investor behavior is profound - and surprisingly contrarian over the year following a trust-damaging event. In this section we review the results of “trust arbitrage” across U.S. stocks and global stock markets to establish where trust is like to lead higher long-term returns.“A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others.”
~ Robert Shiller
MarketPsych's CJ Liu set up a cross-sectional study of the Trust TRMI for individual United States equities. His model first selected the 100 U.S. stocks with the most mentions in the news over the past one month. His model then ranked those stocks by their news Trust TRMI value. At the stock market open on the first day of the month, the model shorted the 20% of stocks with the highest trust (most trusted), and it bought the bottom quintile (lowest trust) stocks. Every month-end the model repeated the ranking and positions were exited and re-established based on the new ranking. The equity curve generated by this model was calculated, as seen below. Zero transaction costs were assumed in the model.
The equity curve above shows that it is advantageous to buy low trust stocks and short high trust stocks on a monthly rotation. This “trust arbitrage” is simple and does not account for timing considerations. Rather, it shows that trust is a useful predictor of prices regardless of what stage of scandal is underway.
Furthermore, the impact of Trust is not only yearly, but also monthly and weekly among stocks. Figure XX shows a monthly equity curve derived from arbitraging Trust in the news about the top 100 U.S. stocks by Buzz - going long the quintile (20) least trusted and shorting the quintile (20) most trusted.
Scandals are likely less common on a rotating weekly basis, and the overall returns are less significant, as seen in Figure XX:
For both news and social media, this effect became significant only after 2012 on a weekly basis. So trust is influential on various time horizons across U.S. stocks, but is it also predictive across global stock markets? Yes, it appears that way in Figure XX, whose equity curve was derived using a yearly model that first obtains the top 20 “trade-able” countries in the news over the past year, and then arbitrages trust by shorting the top quintile (4) trust-ranked countries versus going long the bottom quintile (4) using each country’s major stock index.
Housekeeping and Closing
In these cases we see a specific corollary to Warren Buffett’s assertion, “We buy when others are fearful, and we sell when others are greedy.” We could rewrite that as, “We buy when others have lost faith, and we sell when trust is complete.” As investors, we should learn from scandal - therein lie opportunities. The stupid neither forgive nor forget; the naive forgive and forget; the wise forgive but do not forget.
~ Thomas Szasz
Greece will eventually default, byt necessity. This month is as good as any other for the event. The damage is likely to be significant to Greece, but short-lived. Greece will recover stronger from the event. The global ripples will likely be minor, as players have had time to prepare and have back-up plans.
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Forgiveness is one key to happiness, both as an investor and in life.
Richard L. Peterson, M.D. and the MarketPsych Team
References
Robert J, Shiller. January 27, 2009. “Animal Spirits Depend on Trust: The proposed stimulus isn't big enough to restore confidence.” Wall Street Journal. Downloaded from: http://www.wsj.com/articles/SB123302080925418107
Zak, P. J. & Knack, S. 2001. "Trust and Growth." Economic Journal, Royal Economic Society. 111(470), 295-321.
Bjørnskov, C. 2012. “How Does Social Trust Affect Economic Growth?” Southern Economic Journal. 78(4), 1346-1368.