B.F. Skinner In His Lab
Behavioral psychologist B.F. Skinner was a major proponent of operant conditioning as a means to the modification of human behavior. Operant conditioning involves the use of positive or negative reinforcement to promote certain behaviors, and/or different forms of punishment to discourage other behaviors. It is my belief that whether or not such an approach was intended, in effect the markets have been subjected to Skinnerian behavior modification during the many years of low rates and constant Federal Reserve interventions we have been subjected to since 1998. As a result of this long period of operant conditioning, the markets now behave pretty much as the Fed wants them to at almost all times. The reason this has happened is that the Fed has stumbled upon strategies that directly reward aberrant investor behavior favored by the Fed, and equally directly punish conventional investor behavior not favored by the Fed.
Whether or not this was planned, it has nevertheless come to pass that investors now do as they are expected to do with alarming frequency. The reason this is alarming is because the Fed is about to shift gears to a rising rate mode of operation, while the executive branch is about to shift gears to a fiscally driven set of policies that is likely to move the markets.
In detail, operant conditioning involves the strengthening of pre-existing behaviors by the application of reinforcements or punishments that tend to promote the behavior in question. Since 2008, market players and traders have been given numerous doses of reinforcing stimuli in the form of direct market interventions and low interest rates. This has resulted in a "buy the dips" mentality that is responsible for a whole series of violent market moves involving short squeezes off of intermediate bottoms. The issue now is, what will happen in the markets when the Fed stops intervening and manipulating them, while the focus shifts to fiscal policy? Will there now be a time interval of acute cognitive dissonance, as markets adjust to a world where the dips should not automatically be bought? If history is any guide, the answer is yes. If human nature is any guide (Chart 1), the answer is again, yes.
Chart 1: Upton Sinclair's Comment on Cognitive Dissonance
Take, for example, the huge drop in the markets that occurred overnight after the US presidential election on November 8th, 2016 (Chart 2). The logic used by algo traders and others was that the election of Donald Trump as President of the United States would be a disaster for the markets because of uncertainty and fear; yet the whole thing reversed in a few hours once Mr. Trump made conciliatory statements in his acceptance speech. This violent reversal may be reflective of cognitive dissonance in the face of astonishing new facts. In any case, the sharp rally caught many people short because the logic reversed almost instantly. We saw a similar reversal after the Brexit vote in June, 2016 (Chart 3).
Now to some extent the violence of these reversals is due to the prevalence of algo trading, which has caused much faster and more violent moves in the stock markets from time to time since 2010. But in my opinion, there is also this element of cognitive dissonance, as a set of programmed behaviors (sometimes reminiscent of Skinnerian behavior modification) suddenly runs into a sharp change in the nature of the experiment. When that happens all of the operant conditioning fails to work, and the subjects (i.e., the markets) are forced to re-think the problem. What is most curious to me is the extreme rapidity with which the market reversals have occurred.
Chart 2: Flash Crash and Rapid Recovery On Election Night
Chart 3: Flash Crash and Rapid Recovery After Brexit Vote
It may be that the extreme velocity of the reversals is driven by a sort of mental rubber-band effect, if you will. By this I mean that the sell-off is suggestive of the break-down of operant conditioning, and the subsequent violent snap-back occurs when the markets decide for whatever reason that things are back to normal, so they revert to their standard behavior of massively buying all dips. In B.F. Skinner's lab, the analogous behavior would be a rat working through a maze to get the long-established reward of a food pellet, but then to its surprise, not actually getting the pellet. Erratic behavior results, but then inexplicably the rat gets the food pellet just like normal the next time the maze is run through.
Returning to the markets, there are scary implications if my interpretation of the Brexit and US election night reversals is at least partially true. That is, the markets are going to reach a point where the "buy the dip" mentality suddenly fails, and such a failure might lead to catastrophic results. What if, instead of the reversal to normal behavior typical of the Fed-manipulated market, punters actually decide during one of these binary events that the algo traders have it right after all, and the initial crash is joined by enthusiastic sellers in big volume? The actual failure of the Fed's long-term operant conditioning of the markets could then lead to a massive fear trade, in my opinion. A great example of this kind of event may be found in the October 19, 1987 stock crash (Chart 4). In that event, computer models went awry, but huge numbers of investors joined the panic, and the market dropped by an astounding 22% by the end of the day.
Chart 4: Market Crash on October 19, 1987 (Black Monday)
Investors should be prepared to recognize a break-down in the markets that follows a potential failure of the operant conditioning that has rewarded players for so long. The lead in to the Crash of 1987 consumed three days and could have been used to make a call. Once the market broke below support on October 16th, a signal was there that something big might be coming. In our current situation, with the markets overbought, over-bullish, over-hyped, with market internals in weak condition near all-time highs (Chart 5), and with yields rising, all of the conditions have been met for a sudden and violent market drawdown, according to analyst John Hussman (http://www.hussmanfunds.com).
Chart 5: Market Internals (NYHL) Look Weak Given the All-Time Highs
I would start to build up more defensive positions in anticipation of the Italian vote on December 4th, so it makes sense to hold some intermediate Treasuries: the Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV), the PIMCO Total Return Active ETF (NYSEARCA:BOND), and the DoubleLine SPDR Total Return Tactical Bond Fund (NYSEARCA:TOTL); also some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), the AQR Managed Futures Fund (MUTF:AQMNX), and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Fund (NYSE:BXMX).
Disclosure: I am/we are long BOND, OTCRX, QLENX, AQMNX, BXMX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.