Money & Finance - Dangerously High Levels of Risk Tolerance

We at JSK Partners would like to thank Trader Planet for the opportunity to express our views on the market.

http://www.traderplanet.com/commentaries/view/164122-dangerously-high-levels-of-risk-tolerance-spx/

- Joseph S. Kalinowski, CFA

Money & Finance - Market Sentiment and Returns

This is proving to be quite a challenging year for us as money managers. As ridiculous as this may sound with the S&P 500 and Dow Jones Industrial Average hitting record highs, we have not been successful to date in maximizing profits for our investors. After taking aggressive long positions in early December 2012, we rode the trend nicely into the first quarter and started to take profits into the second quarter as our modeling suggested. Do we look back and regret not staying involved longer? Absolutely! But as the saying goes, hindsight is twenty – twenty and we rightfully adhered to our modeling that has been tried and true year after year. The year is young and we are confident that our returns will be competitive for 2013.

That said, one needs to always look back to analyze the setbacks that led us to this position and learn from past missteps. As we frequently state, we are always a student of the market.

Certainty Bubble

We came across a very interesting article that adequately describes the current state of the market. The author describes the current environment as a “certainty bubble”.  “As an investor, you are barraged with risk – economic risks, personal biases, companies over-stating results, and rapidly shifting trends are just a small sampling of obstacles we all face. I believe another risk has recently emerged and coupled with technology and media advances, is a dangerous investing risk you need to have on your radar.  What is this risk you ask? Inflation? The Dollar? Japanese Central Bank intervention? The next Cyprus? Those may all be risks but this subtlety emerging risk is an expanding bubble in certainty.”

http://www.businessinsider.com/the-emerging-bubble-in-certainty-2013-4

The author goes on to state, “Investment comments and analysis which usually has been represented as opinions, thoughts, or probable outcomes, has somehow experienced a metamorphosis from what is likely to occur into what will occur. Certainty is the new consensus.”

This attitude towards investing, in our opinion is clearly driven by the moral hazard instilled by the Federal Reserve. Overreliance on the “Bernanke put” has brought risk tolerance to new levels as investors view any type of pull-back in the market as an opportunity to increase equity exposure.

This pavlovian response to minor market declines is troubling to us considering it has been quite some time (3Q 2011) since we had a significant (and healthy) market decline. History has taught us that the overconfidence as it relates to the certainty bubble today can lull investors into a false sense of security that can ultimately result in painful consequences. Our view is to try to take an objective look at this stock market and “gather information from those who understand and respect how quickly markets can humble investors, and try to maintain looks over your shoulder at what might go wrong, instead of settling for assurances of what is certain to happen.”

“Bernanke notes that asset prices that are far from historically normal levels are susceptible to destabilizing moves. Are markets currently priced far from historical norms? Wall Street bulls say no but their case rests mostly on the ability of analysts and economists to predict the future, a dubious prospect at best. Economists expect a brief slowdown in the current quarter and an acceleration in the second half of the year. Analysts expect earnings to resume double digit growth in the second half. These soothsayers are telling us to ignore all the current clouds because the sun will shine later this year. What exactly they base this optimism on is a mystery but it could be true and if so, my current insistence on carrying an umbrella will look foolish. If I’m right and asset prices are as high as they appear, we may need hip waders.”

http://www.alhambrapartners.com/2013/05/12/happy-mothers-day-mr-bernanke/

Fed Support

As stated earlier, we believe this current rally is dangerously propped up by the notion that the Federal Reserve will continually drive investors into more risky assets. Last week there was a rumor about a pending Wall Street Journal article by Jon Hilsenrath regarding the eventual slow-down in the Fed’s quantitative easing strategy. The Dow Jones Industrial Average dropped 100 points in minutes. Yesterday the market pulled back from comments out of the San Francisco Fed President reiterating his views that QE should be reined in by summer time and stopped by year’s end.

We believe these market actions are clues as to what’s to come. If we are correct in our assumption that the markets are currently supported by the optimism that Fed policy will always be in place, we may be looking at quite the market decline when the Fed finally offers definitive confirmation of the end of QE.

“The Fed’s new plan is to taper off QE over the balance of the year. Unlike the endings of QE1 & 2 the sunset for QE3 will be a bit of a surprise for markets. The stated intention (according to Hilsenrath) is to change the amounts of POMO purchases on a month to month basis. Reading through the lines, I get the impression that Bernanke is going to lower the QE buys one month, but should the markets react negatively, he would increase the purchases the following month in an effort to “rebuild confidence”.

I don’t see this new policy working at all. It’s the predictability of POMO that gives QE it’s market clout. When the predictability is replaced with uncertainty, the markets will not like it.”

http://www.businessinsider.com/fed-ben-bernanke-leak-2013-5

The bullish case

We remain confident in our market assumptions and our positioning. We have positioned ourselves to take advantage of market weakness when it arrives, but there is always the possibility that we are incorrect about our market assumptions.

There has been fascinating research provided in the field of behavioral finance that can make the case for additional upside even from these frothy levels.

In the absence of uncertainty in the market and global economy, this rally can absolutely be fueled by increasing sentiment. As investor complacency and perception increase, so does return expectations and risk tolerance.

“Momentum-like impact of past returns on subsequent changes in investor optimism and fear (trend following) provides empirical evidence with respect to the psychological factors contributing to the creation of asset-price bubbles… Our results show that the return expectations of individual investors indeed exhibit adaptive behavior with respect to their past return performance.” – Netspar Discussion Paper - Arvid Hoffmann and Thomas Post - What Makes Investors Optimistic, What Makes Them Afraid?

Rational Investors

There is one curious note as it relates to our behavioral model. Throughout this entire bull market that started in 2009, our behavioral model has been quite accurate at pinpointing excessive sentiment levels that preceded market weakness. Our model had started to indicate market weakness as we moved into the second quarter of this year thus urging us to start taking profits on the positions we held. As the model continued its downward descent, we started to slowly build positions inverse the general market.

What has happened since then is a major divergence between our model market actions. We have provided a graphic below to show this. Contrary to many reports regarding investor exuberance, we have yet to see acceleration in this area. The model is capturing a relative lack of enthusiasm in a market where the gains seen are not supported by trading volume in the underlying security (in this case SPY).

This further emboldens of beliefs about a coming correction. While the market continues onward and upward, support for this rally is getting thinner and thinner. That said, should our behavioral model turn decided higher, this would mean investor sentiment is improving and this market will go MUCH higher. We say much higher because our view holds that if the market can get to these levels on muted participation, what will happen when the masses really start to pour their sidelined cash into equities.

Aware of the risk of sounding like we are talking from both sides of our mouth, should this event happen, we will admit to our miscalculation and fix the issue. For the time being our current investment thesis stands.

 

So what if our investment thesis is wrong?

Amos Tversky and Daniel Kahneman are the fathers of behavioral finance and have conducted many studies in their quest to understand the phycology of investors. These are two scenarios that they put forth.

Scenario 1: Imagine that you have decided to see a play where admission is $10 per ticket. As you enter the theater you discover that you have lost a $10 bill. Would you still pay $10 for a ticket for the play?

Yes [88 percent] No [12 percent]

Scenario 2: Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater you discover that you have lost the ticket. The seat was not marked and the ticket cannot be recovered. Would you pay $10 for another ticket?

Yes [46 percent] No [54 percent]

 “The marked difference between the responses to scenarios 1 and 2 is an effect of psychological accounting. We propose that the purchase of a new ticket in scenario 2 is entered in the mental account that was set up by the purchase of the original ticket. In terms of this mental account, the expense required to see the show is $20, a cost which many of our respondents apparently found excessive. In scenario 1, on the other hand, the loss of $10 is not linked specifically to the ticket purchase and its effect on the decision is accordingly slight.”

A major behavioral flaw as it relates to investors is that they compartmentalize positions as opposed to looking at their total portfolio. This is a major reason why investors tend to sell their winners too early and hold their losers too long.

We understand that taking smaller losses for the greater good of the portfolio is at times necessary. 

We construct our thesis based on the information available and do not anchor our views on a specific position.

Bottom Line: We have raised significant cash and have started to position ourselves for a coming market correction. Should we see greater support for this rally show up within our behavioral models, we will have to readdress our market thesis and change course.