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I am married to a clinical psychologist who specializes in neuropsychology. You'll have to believe me when I tell you that I didn't meet her in therapy. Actually, I met her the old-fashioned way: in a bar... on Cinco de Mayo.. with Jose Cuervo as my wingman. The rest is history you won't care about, but I have learned a little bit about psychology and the brain being married to her for the last 11 years.

I like to impress my wife with my understanding of her profession so I'll drop some vocational terms every now and then, like transference, habituation, amygdala, and hippocampus, into a conversation. She of course knows that I don't really know what I'm talking about, but that's the fun of it, because I know her hypothalamus will help her laugh when I do it.

Admittedly, then, I am approaching this week's topic with a bit of intellectual trepidation since I'm venturing into my wife's professional realm to discuss the cognitive dissonance of the stock market.

Cognitive Dissonance Defined

The theory of cognitive dissonance was put forth by Leon Festinger in 1957. It was summed up neatly in a 2008 piece by Saul McLeod, Cognitive Dissonance Theory - Simply Psychology. McLeod writes:

"Festinger's cognitive dissonance theory suggests that we have an inner drive to hold all our attitudes and beliefs in harmony and avoid disharmony (or dissonance). Cognitive dissonance refers to a situation involving conflicting attitudes, beliefs or behaviors. This produces a feeling of discomfort leading to an alteration in one of the attitudes, beliefs or behaviors to reduce the discomfort and restore balance etc."

McLeod goes on to explain that the principle of cognitive consistency was the focus of Festinger's theory and that "...the motive to maintain cognitive consistency can give rise to irrational and sometimes maladaptive behavior."

If you were like me and wondered what maladaptive means, it is defined as not providing adequate or appropriate adjustment to the environment or situation.

Okay, that's enough of the psychology mumbo-jumbo. It is time to show the cognitive dissonance at work in the stock market.

A Belief System

What is it that the stock market believes?

  • The market believes the Federal Reserve will make sure a major stock market correction doesn't occur
  • The market believes the Federal Reserve's monetary policy is going to be effective in getting the economy to grow at, or above, potential again
  • The market believes interest rates are going to stay low for a very long time
  • The market believes the US can weather a lingering recession in the eurozone and a slowdown in China without any major earnings implications; and
  • The market believes stock prices are quite simply destined to trend higher, because the Fed is banking on the wealth effect to help meet its dual mandate

This harmonious belief system has helped carry the Dow, S&P 500, and Russell 2000 to new, all-time nominal highs. There have been periods of dissonance along the way, the most recent of which occurred last month when Fed Chairman Bernanke did an inadequate job of communicating the FOMC's thoughts about tapering its asset purchases.

What ensued was a nasty response from the Treasury market that created a good deal of discomfort in the stock market, as it was presumed the Fed was getting ready to take away the punch bowl. That thinking was not part of the stock market's belief system. In just four trading sessions following the June 19 FOMC press conference, the S&P 500 declined as much as 5.6%.

The Treasury market and the stock market effectively threw a "taper tantrum" with designs on getting the Fed's attention to restore some balance. Sure enough, one Fed official after the next turned out to try and quiet the screaming children. Fed Chairman Bernanke eventually did, too, offering up one, big lollipolicypop with the pronouncement that a tapering decision is going to be data dependent and that, even if a tapering were to occur, monetary policy will remain highly accommodative for the foreseeable future.

Mr. Bernanke restored the market's belief in the idea that the Fed won't let it suffer through a major correction. In the period from June 24 to July 18, the S&P 500 gained as much as 8.5%.

The Great Equalizers

A person who smokes knowing it causes cancer is an example of cognitive dissonance. They know it's bad for them, but they do it anyway, thinking perhaps they won't get cancer, or rationalizing it on the grounds that it reduces their stress level and/or that they are going to die of something someday anyway.

The cognitive dissonance for the stock market is that it knows the economy and earnings are weak, yet it keeps pushing stock prices and valuations higher.

It isn't comforting to hear the IMF and OECD lower their global GDP forecasts. It isn't comforting to hear UPS (NYSE:UPS) warn of a slowing industrial economy that it expects to persist. It isn't comforting to think second quarter real GDP in the US has a chance of being negative. It isn't comforting to see US businesses struggle to increase revenue because end demand is soft. It isn't comforting to see the U6 unemployment rate (the one that captures discouraged and underemployed workers) at 14.3%.

These sources of discomfort, though, are continually minimized on the belief that things will be much better six months from now when the force of easy central bank policy really kicks into gear. And it is thought that central banks won't let things go any other way in the interim. Alas, don't worry. Be happy and buy stocks.

Faith in the Fed and the six-month horizon have been the great equalizers for restoring balance in the face of disappointing news. That mentality isn't new.

The market has shown an abiding faith in the Fed and the six-month horizon for close to five years now. The Fed, of course, has had to go back to the policy well three times to maintain the market's faith in the six-month outlook, but who's counting?

According to Thomson Reuters, it was thought six months ago that second quarter earnings growth would be up 8.4%. It is now thought that second quarter EPS growth might only be up 2-3%, but what does that matter when fourth quarter earnings reported six months from now are projected to be up 12.4%?

What It All Means

The stock market has that carefree attitude about it again. Good news is good news because it shows the Fed's policy is working, and bad news is good news because it means the Fed isn't going to take away the punch bowl. The stock market can thank the Federal Reserve for the umpteenth time for lifting its spirits.

The recognition that the S&P 500 has increased as much as 8.5% in just three weeks, amid a string of downgrades to economic growth forecasts and yet another period of weak revenue growth, is apt to create an impression that buying stocks is a risk-free undertaking with the Fed standing guard.

The stock market likes to go to that happy place, but the reality is that it is not a risk-free undertaking. That cannot be forgotten at a time of cognitive dissonance like this when irrational and sometimes maladaptive behavior is starting to show through to maintain cognitive consistency.

Investors participating in this Fed-fueled rally need to make sure they have strategies in place to guard against downside risk to their portfolios. Fortunately, the cost of protection, as seen in the CBOE Volatility Index trading near a five-year low, is not expensive right now, so it might pay to purchase some portfolio protection on the cheap at this juncture.

At the least, it will help save your amygdala from undue emotional stress that is sure to arise if you are caught off guard by a change in the market's belief system.

Source: The Stock Market's Blissful State Of Cognitive Dissonance