Normalcy Bias

Normalcy bias is a personality trait that causes people to underestimate the possibility and magnitude of extreme events.  When presented with evidence of impending tragedy, normalcy bias leads people to see the warnings through only the most optimistic lens.  At its extreme, it’s a human reaction that leads to the conclusion that, because something has rarely or has never happened, it can’t happen this time around.

What makes normalcy bias dangerous is its effect on personal behavior.  When confronted with dire warnings, people’s responses tend to be binary:  either the affected person will rationally react to the warning (leave New Orleans before the hurricane), or due to normalcy bias, become complacent (try to ride out the storm because the last storm wasn’t so bad and the levees have never failed).

The problem with complacency is that it leads to blind spots, excesses, and is generally followed by sub-par performance.

Now, I’m no psychologist (although some accuse my writing as aptly characterized by the first 6 letters).  I don’t know why normalcy bias exists, considering it is a behavior so clearly detrimental to the safety of the biased individual.  It surely seems like something that should have evolved out of the human race a long time ago.  But it didn’t.  Nor did the complacency it creates.

While this blog post focuses primarily on complacency, I hope it simulates some thought as to whether the symptoms result from normalcy bias or they are simply a rational case of “letting the good times roll.”

Recently, we’re seeing a lot of evidence that complacency is on the rise.  To wit:

  •  NYSE short interest fell by 700 million shares over the final two weeks of 2012
  • NYSE margin debt is the highest it has been since February 2008 and is 22% higher than a year ago.
  • VIX (the “fear index”) is at its lowest level since May 2007
  • VIX has been falling on the same days the S&P 500 has been falling thus far in 2013
  • During the first week of 2013, individual investors:
    • Added $7.4 billion into emerging market funds.  This is the largest weekly inflow ever.
    • Added $8.9 billion into long-only equity funds.  This is the largest weekly inflow since 2004.
    • Added $22 billion into equity funds and ETF’s.  This is the largest weekly inflow since September 2007.
    • Individual investor sentiment is up:
      • 46.4% are bullish; only 26.9% are bearish.  These numbers average 39.0% and 30.5% respectively
      • 55% of American millionaires plan to increase their exposure to stocks in 2013.  This compares to 45% in 2010.

Many in the media have been touting these facts as evidence of a bull market ready to ramp upward.  Bloomberg recently praised the high levels of margin debt as “signs of increasing confidence after professional investors trailed the market since 2008.”

I guess one man’s sign of confidence is another man’s sign of investors chasing forgone returns.

When viewing the above-listed evidence of complacency, I see the fingerprint of normalcy bias.  The Fed has engineered a steadily rising market since early 2009.  Buying the dips has proven to be a profitable strategy.  Every.  Single.  Time.  When the market loses its footing, another round of QE picks it right back up.  The market was never negative on a year-to-date basis at any point in 2012.  The fiscal cliff was averted with no negative ramifications for stocks.

Why then should we be concerned about the geopolitics of Europe or the Middle East, the (likely) impending currency wars, the possible (probable) recession in 2013, the debt ceiling mess, increasing regulations, increasing taxes, increasing money supply, and increasing social stress?

These things are out there for all to see.

Like the repeated warnings in advance of a hurricane’s arrival.

But… not to worry.  We’ll ride out the storm because, after all, the levees haven’t broken in a really long time.



Happy Anniversary Baby, Got You on My Mind

I remember it well.  It was 25 years ago October 19.

  •  The Bangles were walking like Egyptians.
  • Gordon Gekko was slapping Bud Fox around in the park.
  • Mr. Belvedere was cancelled by ABC.
  • Reagan was at the Berlin Wall, punking Gorbachev.
  • Coked-up/coke-dealing stockbrokers were being arrested around the country.

1987 was one hell of a year.

25 years ago today it was Black Monday… the day the stock market had its largest single day percentage loss in its history.  In one day, the market fell 22%.

On that day, I was 59 days into my new career with a regional broker/dealer.

My personal remembrances from that day remain somewhat fuzzy – a mishmash of extreme emotions and mind-bending fatigue.  The day started with a sense of foreboding, since the market had lost 108 points on the Friday prior.  Before our markets opened, Singapore had dropped 33%, Tokyo was down 17%, and Hong Kong had dropped by 11%.  London was down 22%; Frankfurt was down 13%.

90 minutes before the market opened, the phones were ringing.  A lot.

I hadn’t yet sat for my Series 7 exam, so I was not in a legal position to offer investment advice to the callers.  Yet the calls were so numerous that everyone, including me, was picking them up as best as we could.  The company line was “tell the investors to stay the course” and that’s precisely the advice we offered.

Not that it mattered all that much.  At least half of our clients were in open-end mutual funds that wouldn’t be priced for redemption until the end of the day.  Most of the rest were in 3rd party managed accounts (wrapped at 3%, I might add) over which the investor had no discretion.  For those investors, it was going to be a day of watching a video-taped train wreck one painful frame at a time.

When the market opened, things weren’t as bad as we expected.  A bit of cautious optimism began to seep into the office as normalcy bias was on full display.  In retrospect, those feelings were terribly unwarranted – the opening was only moderately weak due to the fact that many stocks had failed to open immediately while their investors were being warned of the impending opening prices.

Once all stocks opened, things got bad.  Later in the morning, things got really bad.

And, being 1987, technology was not what it is today; particularly for small firms like ours.  Order flow in the markets was so extreme, getting a price for placing a sell order was impossible.  A market order, for those desperate to sell, might sit for an hour or more before being executed at an unknown level.

The noise, both physical and mental, was nearly deafening.

There are no patterns in a panic.  A desperate search for information, a desperate crush of fruitless client-assuaging calls, and a desperate on-going attempt to measure the damage.  All these acts being performed randomly by random employees.  “Fire in the movie-house” style.

By the time the carnage was over, the market closed 508 points lower.

I think everyone sat in the office that day until well past 10 p.m.  We really weren’t doing anything productive.  The phones had stopped ringing and the TV’s were shut off.  At the time, most of us were in our mid-20’s; children in terms of stock market experience.  We were feeling like the unlikely survivors of that frame-by-frame train wreck – wandering around zombie-like, with no real sense of what to do now or what was to come tomorrow.

The pervasive emotion I recall at that time was numbness.

By the time I left for home that Monday, I was stepping over Tuesday’s morning paper that was resting by the front door of our office.

Taken in a context larger than that of a regional broker/dealer and a 20-something new hire, Black Monday was the culmination of many factors that converged in a short period of time:

  • By August 25, 1987, the Dow had gained 43% for the year.
  • Before the Crash, 158 companies had split their stocks on the NYSE alone.
  • “Portfolio Insurance” was a popular way to limit your losses.
  • Takeovers had been so prevalent earlier in the year, on October 14th there were open discussions about applying a punitive tax on takeover profits.
  • Germany and the US were verbally engaging in a currency war, culminating with Treasury Secretary James Baker appearing on the Sunday talk-show circuit saying outright, “Either inflate your Mark, or we’ll devalue the Dollar.”  This was October 17th.
  • On September 9th the newly sworn in Fed Chief, Alan Greenspan, made a pre-emptive strike on inflation by raising the discount rate by 50 basis points.
  • On the back of record high trade deficit figures, the Prime Rate spiked on October 15th and the bond market began to collapse.
  • On October 16th a rare hurricane hit London, forcing their market to close and sending European investors seeking liquidity to sell in New York.
  • In the midst of the Black Monday morning, a rumor circulated that the SEC was going to halt the market.  This only accelerated the selling.

Hindsight makes the Crash (at least its probability, if not its magnitude) seem like it should have been expected.  But clearly, that wasn’t the case.

When the smoke cleared and the analysis began, it became apparent that the day following Black Monday had the potential to make Monday look merely like a warm-up.  Banks were no longer willing to accept stock as collateral for their short-term loans to market makers.  Liquidity was sucked from the system, stocks began to crash and be halted, and indexes tumbled.  The day after the worst day ever was beginning to look catastrophic.

In the end, the Fed ultimately intervened, instructing the banks to step up and provide liquidity.

Stocks closed in positive territory on record volume (608, 120, 000 shares) that Tuesday.

On October 21, the market saw its largest one-day percentage gain since 1933, tacking on 10%.

As a newbie, the events of those two days forever shaped my perception of risk.  When this company was founded over 20 years ago, systemic risk management was a central theme.  It remains so to this day.

Brain Damage

The lunatic is in the hall
The lunatics are in my hall
The paper holds their folded faces to the floor
And every day the paper boy brings more

Taken from Pink Floyd’s 1973 hit “Brain Damage, ” these lyrics couldn’t have been intended to portend monetary policy in 2012.  Yet strangely, they do.

The lunatic(s)…  Paul Krugman (or any of his Keynesian minions)

The hall…  The Federal Reserve

The paper…  The US dollar (I have a few folded faces in my moneyclip right now)

The paperboy…  Ben Bernanke

Today, following the thinking of the lunatic, the paperboy brought more paper — $40 billion per month to be exact — to be spent on mortgage-backed securities.  Even better, the paperboy promises to keep bringing the paper for as long as he sees fit.  An open-ended quantitative easing that, to my knowledge, is unprecedented.

And just to make sure there will be plenty of paper in the hall for the foreseeable future, the near-zero fed funds rate will be kept at “exceptionally low levels” until mid-2015.

Risk assets loved the news.  As I type this, the DJIA is up 158 points.  Gold rallied over $23.  Silver bounced nearly 4%.

Equity price discovery is now officially wrecked, at least until mid-2015.  Dollar-denominated commodities should move higher — including seldom used commodities like food and oil.  The Fed’s balance sheet will be ballooning by nearly 1/2 trillion per year.

Those sure sound like great reasons for the stock market to march higher.

I’m breaking out my “Dow 15, 000” cap.  Maybe it will keep my head from exploding.

And if your head explodes with dark forbodings too

I’ll see you on the Dark Side of the Moon

Back to the Future?

Thanks to an article by Richard Whalen, I was reminded that today is the 5th anniversary of the Federal Reserve launching an emergency 50 basis point rate cut in response to Countrywide Financial’s inability to roll its commercial paper.

This was the first canary in the coal mine to drop dead in advance of the worst recession and housing collapse in 80 years.

In honor of this auspicious anniversary, I’ve decided to do something a little different with the blog in the upcoming weeks.  You see, we all have crystal clear hindsight regarding the financial meltdown, but what was the prevailing mindset in the weeks leading up to the disaster?

To answer that question, each week I will be posting Minyanville’s “Week in Review” from the appropriate week in 2007.  The first such post follows.  A word of warning, however…  There are some eerily similar “whistling through the graveyard” comments in these posts.  To wit, note how good durable goods and new home sales numbers were holding the market up on August 24, 2007.  Yep.  New home sales.

Market Recap

After the late summer’s wild ride, markets stabilized this week as the VIX dropped 25%. The SPX was able to retake its 200 day moving average as renewed takeover chatter resurfaced mid week while the DJIA retraced over 50% of its losses. Despite a sluggish Thursday after Countrywide’s (CFC) CEO dropped the “r word” investors’ jitters were eased after Friday’s upbeat durables and improved new home sales report.

With a lot of traders away from their desks next week before the Labor Day weekend, markets should be fairly range bound. It’s similar to a heavyweight fight… after several rounds of delivering heavy blows the Bulls and the Bears are now in the middle of the ring leaning on each other trying to catch their collective breath. When traders return to their desk post holiday, the battle will continue. With the damage done to the financial complex and the latest bounce coming on light volume, probabilities lie in retesting the August lows. For the Bears to gain the upper hand they must crack SPX 1375 and consequently cause the VIX to explode and the BKX to fall out of bed. Bulls need to hold above 1425 to change the psychology of the tape before moving higher and forcing the shorts to cover. Minyans it is important to remember during these volatile times… nobody likes a draw.


Finally, an accounting of the Fed Loans to the TBTF Banks (and some others)

Due to the Freedom of Information Act (and some concise consolidation of the data by Bloomberg) we now have a clear picture of the extent of loans that were extended to US and foreign banks at the peak of the mortgage crisis.  The text that follows came from an article written by John Hayward of Human Events, a self-professed “conservative voice.”  Since it is an informal policy of this blog to avoid political opinion, I’ve redacted most of the partisan commentary from Hayward’s article, but retained the factual elements.  To me, the last paragraph is the most stunning.  The sheer size of the loans, both absolutely and relatively is hard to grasp.

Feel free to draw your own conclusion as to whether the secrecy of these loans was required to insure faith and confidence in the institution to which these loans were awarded.  I understand that an economy runs on confidence, but MAN…  these were some serious loans!

Bloomberg News reports that the full extent of the loans issued by the Federal Reserve during the mortgage crisis has been made public at last.  The list of loan recipients was kept secret until now:

Citigroup Inc. (C) and Bank of America Corp. (BAC) were the reigning champions of finance in 2006 as home prices peaked, leading the 10 biggest U.S. banks and brokerage firms to their best year ever with $104 billion of profits.

By 2008, the housing market’s collapse forced those companies to take more than six times as much, $669 billion, in emergency loans from the U.S. Federal Reserve. The loans dwarfed the $160 billion in public bailouts the top 10 got from the U.S. Treasury, yet until now the full amounts have remained secret.

Fed Chairman Ben S. Bernanke’s unprecedented effort to keep the economy from plunging into depression included lending banks and other companies as much as $1.2 trillion of public money, about the same amount U.S. homeowners currently owe on 6.5 million delinquent and foreclosed mortgages. The largest borrower,  Morgan Stanley (MS), got as much as $107.3 billion, while Citigroup took $99.5 billion and Bank of America $91.4 billion, according to a Bloomberg News compilation of data obtained through Freedom of Information Act requests, months of litigation and an act of Congress.

It wasn’t just [U.S. companies, pardon the redaction] sipping at that trillion-dollar bowl:

Almost half of the Fed’s top 30 borrowers, measured by peak balances, were European firms. They included Edinburgh-based Royal Bank of Scotland Plc, which took $84.5 billion, the most of any non-U.S. lender, and Zurich-based UBS AG (UBSN), which got $77.2 billion. Germany’s Hypo Real Estate Holding AG borrowed $28.7 billion, an average of $21 million for each of its 1, 366 employees.

The largest borrowers also included Dexia SA (DEXB), Belgium’s biggest bank by assets, and Societe Generale SA, based in Paris, whose bond-insurance prices have surged in the past month as investors speculated that the spreading sovereign debt crisis in Europe might increase their chances of default.

As Bloomberg News reporters Bradley Keoun and Phil Kuntz note, the amount of these loans was triple the size of the federal budget deficit in the year they were issued.  (The deficit has, in turn, tripled since then.)  The $1.2 trillion sum is roughly equivalent to the value of the 6.5 million delinquent and foreclosed mortgages in the United States.  It’s over seven times the amount of the $160 billion bank bailout we knew about, while these loans were kept secret.  It’s more than “the total earnings of all federally insured banks in the U.S. for the decade through 2010.”  Only fourteen nations on Earth have a larger GDP than the amount loaned out by the Fed.

90% of the Federal Reserve’s spending in the name of stability was kept secret from the American public, because “releasing the identities of borrowers and the terms of their loans would stigmatize banks, damaging stock prices or leading to depositor runs, ” according to the Bloomberg report.