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.

LL

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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.

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