Jefferson V. DeAngelis

Jefferson V. DeAngelis


February 27, 2018

Humans have an innate tendency to discern patterns and connections between otherwise unrelated things. Psychiatrists have termed this ability as apophenia. It’s an essential trait to make sense of an otherwise random world. Yet, as with so many aspects of the human psyche, too great a tendency is debilitating. At the extreme, excessive apophenia is common among those suffering from schizophrenia. Milder cases express themselves as what we know as confirmation bias, the gambler’s fallacy, or, put scientifically, Type I error. Noted skeptic, Michael Shermer, refers to this ability at self-deception as “patternicity,” the erroneous “finding of patterns in meaningless noise.”[1]

Investors are not immune and indeed may suffer from apophenia more than others given how often they attribute their success to identifiable, correlated factors which in fact are merely random events. Perhaps, it’s their collective intelligence, the success of capitalism or a favorable governmental policy. Maybe it’s just a tip that they received from a friend. Even our president is guilty of trying to take credit for the recent run-up in stocks. It’s doubtful he will be as accountable for losses were they to occur. It is consistent with human nature to justify high prices as rationally based on fundamental factors. Lower prices are often the result of technical factors. The speculators, machines and algorithms are never the cause of the run-up in prices but are always blamed for the declines.

A recent survey by Bank of America shows that most investors believe the stock market to be overvalued. Most analysts have warned about the potential of a correction since last summer. For the last several years, investors have positioned themselves for higher interest rates. Why then is everyone so surprised when interest rates finally rise, and the stock market experiences a true 10% correction? Investors have become complacent and not conditioned for losses. The central banks which underwrote the risk are now withdrawing.

It certainly changes the narrative. No longer can we believe that a modest increase in interest rates is positive for equity markets. The environment of higher price to earnings ratios depends on low rates. We must acknowledge that the Fed has begun a tightening cycle and intends to normalize interest rates and reduce its balance sheet. Equities are not risk-free. In fact, the extended period since the election was an anomaly, not a new era. As investors, we now must experience risk to earn higher returns. This should separate true investors from the tourists that hopped on the return bus.

Another recent reminder of investors efforts to discern patterns was the crash of volatility trades. Volatility is not an asset class. It’s a calculation of risk. The side bets on risk proved to be self-fulfilling. Machine trading like machine learning is going to take some time. Not everything has a static correlation and rarely do historical patterns repeat themselves. Passive investing may be efficient and low cost, but it commoditizes asset classes. Passive investors tend to focus on asset allocation and not selection. This can create significant distortions in the pricing of individual securities and volatility. For instance, the valuation of many large-cap equities has been positively influenced by rapid flows into ETF’s and will likely decrease significantly when, and if, money flows out of the sector.

We should come to realize that the 24/7 news cycle does not in any way alter the sheer randomness of short-term market moves. After the fact, we always seem to know why something happened without an understanding of the cause. The rationale for price movements almost always lags the actual variation of price moves. Something was bound to disrupt the steady rise in stock prices as the accent steepened. Prices are set at the margin and at some point, the marginal buyer becomes a marginal seller. The catalyst for the move is as difficult to predict as an earthquake or avalanche. The only certainty is that conditions for a change were ideal. Was it the fact that interest rates finally started to rise or that the dollar unexpectedly fell? Interest rates have been rising and the dollar falling for over a year. Perhaps, it was the speed of the move; or maybe stocks are just too expensive given future economic prospects.

Investors want to believe that the recent market action is a mere correction in a larger bull market in equities. The consensus believes that synchronized global growth and rising earnings are not the backdrop for a bear market. However, the top in any market is the point of maximum optimism. Markets tend to discount the good news well in advance. A better indicator of a bear market is the character of the bull market that preceded it. If its momentum is strong and waning, its valuation stretched and its breadth narrowing as its popularity increases, it is a candidate for a change. As the great Benjamin Graham is claimed to have once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Fiscal stimulus eight years into a tepid economic recovery is sure to boost cyclical inflation and deficits. The outlook for bonds has deteriorated in the short run. In a highly leveraged global financial system, higher interest rates are a threat to a successful policy outcome. Stocks are beginning to discount late cycle economic risk in which higher inflation and interest rates undermine the attractiveness of earnings and ultimately pull economic growth lower.

Stocks can no longer be considered the double-digit risk-free rate. Investors who seek higher returns must accept higher risk. Complacency is for treasury bond holders of which there are few. Credit risk is not a hedge for equity risk. With the 10-year Treasury approaching 3% equity investors should expect a historical risk premium of 3% and an average return of 6% over the next decade. Given trailing equity returns, one is supposed to assume lower future returns.

The buy the dip crowd will certainly be there along with corporations hungry from tax cuts for additional buybacks and increased dividends. The increased volatility will frighten some investors into fixed-income alternatives. Bonds, however, look less attractive until the economy and inflation slow. The backdrop of larger deficits and debt in combination with a reduction in the Fed’s balance sheet will lead to a muted return environment for all asset classes. The next recession is still probably at least a year away, but you are beginning to see the factors that will lead to it.

When a statistical model fits the noise better than the signal, it’s said to have overfitted the data. Apophenia epitomizes the overfitting of events. Things happen from time to time without any explanation or reason. Suffice it to say that we spend too much time in search of the cause. Take it as a warning sign that investing in financial markets have been too good for too long and are beginning to discount a riskier environment.


[1] Michael Shermer (2008) “Patternicity: Finding Meaningful Patterns in Meaningless Noise,” Scientific American.


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2018-02-28T12:01:14+00:00 By |