When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.
~ Chuck Prince, then CEO of Citigroup, in an interview with the Financial Times published July 10, 2007

At a party last weekend, I sat for a chat with a few of the guys. The conversation turned to careers, and one man explained, "I've got a great new job with a startup. I'm based in Denver now, flying all over for meetings. The start-up is 15 people, but we could easily be at 150 in a year." He went on to describe what sounded like a very exciting job, but after 5 minutes I realized it wasn't clear what he did for a living, nor did I understand the startup - neither its name, line of business, nor his role in the company.

The conversation was stimulating, but I began to wonder if this conversation was evidence of a bubble. I was reminded me of the shoeshine boy offering stock tips before the stock market crash of 1929.

As we discussed in this past newsletter, bubbles create - and destroy - immense wealth. And as noted here, it is vitally important not to lose the wealth we gain during a bubble. As a result, spotting bubbles and timing their demise is a key discipline to growing and maintaining wealth.

Despite the negative returns in bank prop trading and hedge funds this year, there is finally a party on Wall Street. It took several years post-crisis for stock day-traders (i.e. the investing equivalents of underage drinkers) to emerge. But here they are, enjoying massive volatility (mostly positive) in electric vehicles, biotechs, 3-D printing, and other high-flying stock groups.

Today's newsletter addresses the question - "Are we in an equities bubble?", and if so when should we exit. It goes on to offer a risk management checklist to keep you grounded when your investments are performing well.

When Everyone Has a Start-up

Taxi drivers told you what to buy. The shoeshine boy could give you a summary of the day's financial news as he worked with rag and polish. An old beggar who regularly patrolled the street in front of my office now gave me tips and, I suppose, spent the money I and others gave him in the market. My cook had a brokerage account and followed the ticker closely.
~ Bernard Baruch, describing the scene before the 1929 stock market crash

I noticed the above quote in an article published in Fortune magazine. The author of that article fretted that the U.S. stock market was in a bubble. Guess when that Fortune article was published?

April 1996.

That's right, experts were worried about a stock market bubble in Spring 1996, long before the real internet bubble was inflating. Alan Greenspan was also early to the bubble-spotting party, giving his "irrational exuberance" speech on December 5, 1996.

The key to investing in the midst of bubbles is not only to know that they are happening, but also to have a timing strategy for when to enter, and when to leave.

Always Leave the Party When You Are Having Fun

Like Chuck Prince, I used to try to squeeze every pleasurable moment out of a party. I was often the last to leave. But this strategy was the opposite of my wife's.

After my wife and I first met, we attended a number of social events to meet each others' friends. These were fun for me, and I enjoyed getting to know her friends and family at length. But after a few parties, something started to bother me.

I noticed that when the party seemed at it's best, she'd touch me on the elbow and whisper, "It's time to go..." I'd look at my watch, gaze at her uncertainly, and say, "but it's just getting started..." She'd look back at me with concern - "really ... time to leave." She is a social genius, so I figured there was some method to this apparent madness. But I had to know what was going on.

"Why are we leaving these parties so early?" I asked.
"We're not exactly leaving early" she remarked, somewhat mysteriously.
"Seems like the party just gets going and then you want to leave."
"Right." she responded
"Why is that?"
"Rich, you think those parties are so great BECAUSE we leave when we do."
"I don't get it."
"Haven't you heard, 'Always leave the party when you're having fun'?"
"Um, well, no."
"Trust me on this..."

I can be a fairly concrete guy, but she was on to something. Leaving the party at its best is a strategy to maximize one's memory of the event. In behavioral economics it embodies a principle called the peak-end rule.

The Peak-End Rule

If you haven't read Daniel Kahneman's book Thinking Fast and Slow, and you're reading this newsletter this far, then it's probably time you picked up a copy. This book contains profound research-based insights into how humans make decisions. It has a lighter writing style than his academic papers, and I think it's the best single book on behavioral economics ever written.

In one study he performed, Kahneman et al (1993) submitted experimental subjects to:
1. Exposure of one hand for 60 seconds to 14ºC ice water followed by exposure to 30 seconds of 15ºC ice water.
2. Exposure of one hand for 60 seconds to 14ºC ice water.
Both exposures are very painful. Amazingly, subjects preferred the first experience, which is counterintuitive. They preferred a longer overall exposure to ice-water and greater overall pain. The reason for this preference was the gradual increase in temperature after 60 seconds. Kahneman found that our memory of pleasure or pain from an experience is the average of the peak experience and the ending experience, called the Peak-end rule.

Kahneman and others also tested exposure to positive experiences. For example, television commercials that induce positive feelings are rated more highly if the commercials have high peaks of intensity and strong positive endings (Baumgartner et al, 1997). Diener et al (2001) found that participants rated a wonderful life that ended suddenly as better than one with the addition of mildly pleasant years, which they termed the James Dean effect.

The James Dean effect is rooted in a common misperception that people should leave early, believing an early departure will increase their overall happiness (because their memories will be happier). In the financial markets, this is akin to the desire to cut winners short. For a fun party, leaving at the high leads to a more positive memory.

As Kahneman discusses in his book, many people behave in ways that are designed to build better memories. For example, would you pay less to go on a vacation that you were guaranteed to forget afterwards - complete mind-erasing of the entire experience? Of course you would pay less, in fact you may not even want to take a vacation at all if there would be no memory of it. We often set our future plans based on the peak and end memories we anticipate.

Launching your own start-up? If you're in an optimistic state of mind, then surely you will have some awesome peaks and hopefully a buyout (positive peak and end) in the equation. And if you're optimistic, you won't be able to imagine the stress and hassles you are likely to experience. As a result, start-ups are often seen as a good idea during optimistic periods.

So in the midst of a party, if you want to have the most positive memories, waiting for the crowd to dissipate is likely too late. The key to the best memories is knowing when you're in a peak experience, and leaving while the glow from that remains.

Truth be told, the strategy doesn't make sense if you're attending a party for practical reasons, such as networking or achieving an objective, since those goals have nothing to do with your remembered pleasure. But it's not only my wife and a Nobel-prize winner who recommend leaving on a high note, Seinfeld's George Castanza practiced the same strategy.

Leaving on a High Note

In the comedy series Seinfeld, George Castanza was one of Jerry Seinfeld's hapless friends, with big dreams but little success (beyond entertaining the audience). In one episode, George found that if he left a social situation on a high note - following a joke or great idea - others were more appreciative of him in later interactions: video.

But as I mentioned to my wife, it's hard to exit on a high note. When you're on a roll, you want to keep going. In this Seinfeld segment, when George tried to follow one good joke with another, it fell flat and led to a worse overall outcome: video. George tried to add to his string of social successes, only to lose all of the social capital he had accumulated from his prior good jokes.

Sometimes we press our luck too long out of fear of regret. We don't want to miss anything good, but end up overstaying our welcome.

The Bubbleometer

Markets can remain irrational a lot longer than you and I can remain solvent.
~ John Maynard Keynes

The Wall Street Journal notes this weekend that reality is setting in for 3-D printer makers. We are seeing, and have been seeing, rotation from one leading industry to another. Sagging biotechs, electric vehicles, and 3-D printer stagnation indicate we could be in for a rout in speculative momentum shares, probably over the summer and into the Fall. But the U.S. equity market as a whole?

Bull markets and bubbles can inflate indefinitely, and timing the rising and popping of bubbles is obviously of immense interest. At MarketPsych we developed a text-analytics derived index for specific assets - the Bubbleometer - to capture the amount of speculative conversation in social and news media minus analytical conversation about that asset. Speculative conversation consists of references to future price outperformance as well as the expression of positive emotions. Analytical conversation consists of references to accounting fundamentals as well as expressions of pessimism and fear.

The Bubbleometer, to our pleasant surprise, is consistently inversely correlated with asset prices on a one-year horizon. In particular, a 12-month average of our Country-specific Bubbleometer based on global media shows an inverse correlation with future 12-month country equity returns (p<0.05) even after controlling for prior GDP change, stock market returns, and the country's world bank development status. We also see that the Bubbleometer is inversely correlated with 12-month currency price changes (p<0.001). These correlations were tested over the duration of our media dataset (1998 to the present).

Does this mean we should short when the Bubbleometer is high? Not exactly, timing is everything.

Basic and Professional subscribers have access to the Bubbleometer below.

Trading Corner

In order to know when the party crowd is going to dissipate, we've got to understand what they are enjoying about the party. The parallel with the markets is in what topics investors are tracking that are fueling their optimism. During the internet bubble of 1997-2000, "Click-throughs" and "Eyeballs" underpinned valuations. At the bottom of recessions investors watch cash flows. Investors in China are watching bank lending, PMIs, and shadow credit. And now in the U.S., what is driving the rally higher?

To see our investment perspective please sign up for the Basic Plan or the Professional plan. Please contact us directly if you represent an institution.

Historical Examples of Bubbles Popping

When sentiment makes a substantial move it is either:
1. A reaction to a price move (the usual cause), or
2. A prediction of where prices are likely to go. This is the most valuable use of sentiment.

Why does #2 matter? Because humans value changes, not states.

Historically, we saw a dive in sentiment before the S&P 500 sold-off in August 2011:

What will happen next?

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Complacency and the House Money Effect

If people knew how hard I had to work to gain my mastery, it would not seem so wonderful at all.
~ Michelangelo

While some investors are inclined to leave the party early (cutting winners short - like my wife), others (those with high expectations/reference points - like me) play fast and loose with their gains. This excessive risk taking with gains is called the House Money Effect and results in complacency and a failure to manage risk when the future looks bright.

For traders and active investors, a checklist like the one below can help keep you from falling prey to the house money effect:

1. What is your conviction about each investment? Is each sized according to conviction?
2. Check in with yourself. Warnings signs are:
- Feeling very high conviction/confidence after a move in your favor. This could lead to complacency and a failure to adhere to risk management.
3. Have any of your positions moved what you expected them to move?
- Did you get out when your target was hit as you had planned?
4. Is a position that has performed well reverting?
- Most top investors don't allow more than a 1/3 setback before exiting with their profits.
5. Are you following your “best practices” for increasing position sizing?
- Many top traders increase their position size as the position moves in their favor (optionality), but they also are quick to exit when a reversal begins.

The first goal of using this checklist is gaining awareness. If you are violating a "rule" you set, then you should first become aware of it.

We coach professional and institutional investors to optimize their decision making. Contact us by responding to this email for more information.

Closing

Things do not change; we change.
~ Henry David Thoreau

As the U.S. equity market wobbles at all-time highs, remember to re-orient yourself to 1) what has been driving prices, and 2) your risk management strategy. Sometimes we are torn by the fear of regret that we will leave the party early, missing out on further gains. Other times we leave immediately, hoping to capture the peak experience and cutting our winners short. Remember to know your time horizon, stick to your strategy, identify the drivers of price action, and mitigate your weaknesses.

We’ve got speaking engagements globally this Spring. Please contact Derek Sweeney to book us for a talk or training at one of your events: [email protected], +1-866-727-7555.

Please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor market psychology and macroeconomic trends for 30 currencies, 50 commodities, 130 countries, 50 equity sectors and indexes, and 5,000 individual equities extracted in real-time from millions of social and news media articles daily.

We love to chat with our readers about their experience with psychology in the markets and with behavioral economics! Please also send us feedback on what you'd like to hear more about in this area.

Happy Investing!
Richard L. Peterson, M.D. and the MarketPsych Team

References

Baumgartner, H., Sujan, M., & Padgett, D. (1997). Patterns of affective reactions to advertisements: The integration of moment-tomoment responses into overall judgments. Journal of Marketing Research, 32, 219-232.
Diener, E., Wirtz, D., & Oishi, S. (2001). End effects of rated life quality: The James Dean effect. Psychological Science, 12, 124-128.
Kahneman, D., Fredrickson, B. L., Schreiber, C. A., & Redelmeier, D. A. (1993). When More Pain is Preferred to Less:. Adding a Better End. Psychological Science, 4(6), 404.

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