Global markets have failed to melt down. In fact, both the All Ordinaries and the ASX 200 are up as we approach the lunch hour. Though this lack of drama has disappointed the mainstream media (always eager for a big story) it gives us time to revise our Japanica! metaphor for the current stock market paradigm.
“Call it japonica with an ‘o’ and you get a species of flower that loves full sunlight, needs well-drained soil, and is classed as ‘hardy.’ The credit bubble down to a tee!” writes our former colleague in London Adrian Ash.
Hmm. Sure enough, lonicera japonica-otherwise known as Japanese honeysuckle-is considered an “invasive species” by the people who consider such things in the United States. That’s because it is not native to North America, but comes originally from Asia, mostly Japan, China, and Korea. In at least two American states (Virginia and Illinois), it is considered a “noxious weed,” displacing and killing indigenous plants and trees.
Credit bubbles do indeed have a way of working themselves into just about every asset class, crowding out real balance sheet analysis and indiscriminately raising the nominal price of everything they touch. In the springtime of growing things, this is beautiful.
Consider another “invasive species” in North America, the Kudzu vine. If you were to take the train south from Washington D.C. any time between early April and early October, you’d find the scenery along the train tracks to be draped in a pleasant blanket of leafy green.
This blanket is the kudzu vine, also known as Pueraria lobata, a climbing vine native to Asia which has eaten the American South, road by road, power line by power line, bridge by bridge, like a relentless creeping army of green leaves. Because its leaves are deciduous, the winter makes the railroad corridors on the east coast look like an elaborate skeleton of grey tentacles.
But enough of the botany metaphors for the credit bubble. The bubble is, after all, a monetary phenomenon, from the Kingdom of central banks, the order of bad monetary policy, the family of low interest rates, the genus of morons, and the species of stupidity. When the growth of a thing crowds out all other things, we are inevitably reminded of Gresham’s law. Bad money tends to crowd out good money.
We submit that borrowed money, at least these days, is “bad” money, if only in the sense that it is money not well spent, or capital poorly allocated. Just think of all those sub-prime lenders in America who are now going bankrupt. They’ll never get their money back. And the folks that borrowed the money, they won’t have anything to show for their foray into the housing market except a defaulted mortgage and a destroyed credit rating. And a loss of confidence.
And what about all those global speculators who have been borrowing yen to invest in other, higher yielding assets in emerging markets? Where will they find the money to pay back their yen as the yen itself increases in value? They’ll probably have to sell something. But to whom? And for how much?
These are the problems we face in the financial economy. But it’s important to point out that the real economy still chugs along. Thus, the meltdown in China’s shares should not, at least not yet, put a major dent in China’s appetite for Australian resources. Only a total collapse of China’s rickety capital markets could do that. And though China has little experience with robust capital markets, this week’s action looks more like growing pains to us than death throes. It is all a matter of perspective, isn’t it? Or perhaps framing is a better word.
That brings us back to Kahneman and Tversky and their study on how people deal with risk. In another paper published a few years after the first one (The Framing of Decisions and the Psychology of Choice), the two added some more details of why people choose certain lower returns over the chance of higher returns and why they almost always seek risk when faced with the prospect of losing money. If this doesn’t fascinate you, we apologize. But we admit we are fascinated with why people nearly always do the least rational thing in markets.
“The frame that a decisionmaker adopts is controlled partly by the formulation of the problem and partly by the norms, habits, and personal characteristics of the decisionmaker.” We’re with them so far. The facts are the facts. But you bring to the facts yourself, and all your experiences, prejudices, quirks, and nervous ticks.
Kahneman and Tversky then explain that the “frame” people put on the facts is what largely determines the decision they ultimately make. In other words, people aren’t really rational. Faced with exactly the same outcome framed two different ways, what people will choose depends on how the problem is presented to them, which is not as it should be, if you believe that men are rational. Then again, we once enjoyed half a pigeon, stuffed with field mushrooms and wild rice, until we found out it was pigeon and not a chicken, at which point we drank half a bottle of red wine to wash the taste out of our violated mouth.
“Rational choice requires that the preference between options should not reverse with changes of frame. Because of imperfections of human perception and decision, however, changes of perspective often reverse the relative apparent size of objects and the relative desirability of options.” Pigeon tastes better as chicken than it does as pigeon.
How about a non-culinary example? Here is a hypothetical problem. Australia is preparing for an outbreak of an exotic swine flu, which will make its way from Shanghai to Sydney on a Qantas flight in a fictional Airbus A-380 next Wednesday. Your scientists tell you all 600 passengers will die without an program to treat them. You must choose between two programs to combat the outbreak.
If program A is adopted, you can save 200 people for certain. If program B is adopted, there is less certainty. You are told that there is a one-third probability that all 600 people will be saved and a two-thirds probability that no people will be saved. Which program will you choose, A or B?
In Kahneman and Tversky’s study, 72% of respondents chose program A and 28% chose program B. The certainty of saving 200 people was the deciding factor, or so you would conclude from a psychological and statistical perspective. But what if you framed the exact same outcome in a less positive way? What would you choose then?
Here’s the choice framed differently. If program C is adopted, 400 people will die. If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability that all 600 cramped passengers will die on the plane before it touches down near Botany Bay.
When framed this way, just 22% of respondents chose program C while 78% chose program D. Nothing has changed in terms of probabilities our outcomes. The difference between saving 200 people for certain and killing 400 people for certain is a matter of semantics, or, perhaps, morals. But that difference is enough to change the way people behave when faced with a decision about risk and loss. Framed one way, people chose a certain smaller benefit over the chance of an even larger benefit. Framed another way, they chose the option with lowest probability.
In both cases, faced with a limited gain or a large loss, people seem to make the irrational choice. What you find out is that people treat gains and losses differently, and not at all rationally. “Choices involving gains are often risk averse and choices involving losses are often risk taking,” the authors conclude. In other words, our decisions about risk are influenced more by our attitude than a rational consideration of probabilities. When given the chance to make a lot of money, we tend to get conservative. When faced with the possibility of losing a lot of money, we become reckless.
Maybe this is why Warren Buffett says that the key to being a good investor is being “Greedy when others are fearful and fearful when others are greedy.” When you behave counter-intuitively, or as a contrarian, you are more likely to buy low and sell high. But if you accept the frames on the market that the folks at CNBC present to you, you’re likely to sell at the bottom and buy at the top. Or these days, you’d be encouraged to sell your gold and buy short- term U.S. Treasury bonds.
It’s not exactly shocking, this revelation of what drives behaviour in markets. But it is useful, As Benoit Mandelbrot explains, “Prices are not driven solely by real-world events, news, and people. When investors, speculators, industrialists, and bankers come together in a real marketplace, a special, new kind of dynamic emerges-greater than, and different from, the sum of the parts.”
We call this dynamic a “bull market” when investors have a frame of expectations that roughly match reality. We call it a “bubble” when the frame of the market no longer matches the underlying economy. We call it a “bear market” when the false frame collapses after its contact with reality. And we call it a “buying opportunity” when the bear market frame becomes utter despondency and capitulation.
But right now, the bullish japonica frame still holds sway in global markets, despite this week’s buffeting tremors of volatility. It takes a lot to shake a man from an irrational conviction. Only complete disillusionment will do. But make no mistake, in it’s on its way.
And on one last note, speaking of frames, have you seen channel Ten’s ads about saving the planet? “Our planet is dying!” we are told. The ad then promotes a program on Sunday called “Cool Aid,” where we are promised solutions we can implement to “save the planet.”
Hmm. This reminded us of Kool Aid and Jim Jones and his cult in Guyana in 1978 (nearly 1979). Jones, who believed he was the reincarnation of both Jesus and Lenin (ambition!), encouraged hundreds of his followers to drink from a bath tub full of grape juice, laced with cyanide and tranquilizers.
The climate is changing. In fact we like the cooler autumn air. But we hope we can avoid the coming mass hysteria about global warming, and all the bans and prohibitions that will be done in the name of “the planet” and “the people.” That change in the public climate for discourse has historically proven to be the most disastrous thing the species has to deal with, a self- inflicted wound of group-think mob behaviour that’s definitely not rational.
In other words, whenever people get together in big crowds and start demanding changes and start chanting songs, they begin acting like very dangerous morons. Call it democracy if you’d like. But for some reason, it’s starting to smell a lot more authoritarian.
Markets and Money