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Profiting From Pavlov's Puppies

|Includes:Renaissance IPO ETF (IPO), SNY

Ivan Pavlov stumbled onto classical conditioning quite by accident. He noticed that after he fed his dogs, they started to drool whenever he walked into the room whether or not he was offering more food.

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Pavlov learned that objects or events that dogs associate with food can trigger emotional and physical responses. In the equity market, there can be similar Pavlovian conditioning. The stimulus of making or losing money creates a strong emotional and physical response. Both my favorite short and my favorite long idea for next year are efforts to exploit Pavlovian conditioning that has created a strong positive or negative association wholly apart from their respective values.

It is not hard to find examples of positive stimulus that could lead to positive responses in December 2013. But perhaps one of the strongest is the euphoria connected with the past few years' IPOs, especially technology IPOs. Here is the year to date performance for the FTSE Renaissance IPO Composite Index.

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Anyone who has made a substantial amount of money in such investments are probably conditioned to react like Pavlov's drooling puppies.

Once the Pavlovian response has conditioned investors to associate this opportunity with the pleasure of making money, a second factor comes into play - apophenia. Apophenia is a bias in which we perceive patterns where none exist. Everyone suffers from apophenia to one extent or another. It is easy for anyone, especially anyone who has been favorably conditioned towards IPOs, to look at such a chart and linearly extrapolate its future pattern. The reality is that it can go in either direction with nearly any magnitude… for a while. But eventually it will revert to making sense. "Eventually" is likely once many insider lockups expire next year. Thus our best short idea for 2014 is IPO.

Why do we mistake randomness for patterns? It is not a bug, but a feature of human cognition. The costs of Type I (recognizing a pattern that does not exist) and Type II (not recognizing a pattern that does exist) errors are asymmetrical.

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The caveman who kept seeing tigers when it was really just grass was annoying, but he still may have been able to pass on his genes. The caveman who kept seeing grass when it really was a tiger was tiger dinner and as such was an evolutionary dead end. Certain cognitive biases such as apophenia survived evolution because of a reproductive benefit. However, when it comes to perimutuel games such as the stock market, they stink.

Where in today's equity market can be found Pavlovian dread? Examples are far and few between. At Christmas parties across Fairfield County, the only complaints one hears are ostentatious moans about impending tax bills and the tragedies of few if any tax losses to harvest. The market has gone straight up all year in every sector of the economy. Who owns any loser anywhere? Who has even heard of one? Alas, I do! For the winner in the search for Pavlovian dread as well as my forthcoming best long idea for 2014, I present the Sanofi (NYSE:SNY) Contingent Value Right (NYSEMKT:CVR): GCVRZ.

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The performance over the past quarter has been catastrophic. The fear is palpable. Thinking about such a security, let alone owning it, could be a firable offense. A major catalyst in the form of an important Food and Drug Administration (FDA) decision that impacts GCVRZ is due on Friday December 27th, mere days before New Year's Eve also known as when bonuses are judged. Is this when or where anyone wants to take a risk? No. This is where the Pavlovian response to a vivid recent catastrophe is dread. Just thinking about this one, I have a mild headache and nausea. Then, once apophenia kicks in, one can see which direction this chart goes: straight down.

But, there is more. Once we forget about sunk costs and set aside the looming issues surrounding the FDA, what happens? For a moment, just count. Add up the various foreign markets, apply conservative but reasonable premises, and compare the likely rewards with the cost of this security. It appears that the likely payments are probably a multiple of the current price. But at least one comment below or following the article that will be published in the morning will respond, "what? But that is a terrible idea because it is down so much!" To preemptively address that response, we are only human and that is why we are conditioned to think that way. That is why it is so cheap and that is why it is my best investment idea for 2014.

Stocks: IPO, SNY