In June, Raboud University in the Netherlands, discovered something interesting about the human brain as it relates to visual information. It turns out that we see not just with our eyes, but with the brain as well. In the image to the right, no triangle exists, but it is implied by the placement of the 3 Pac-Man shapes relative to each other. Prior to the recent findings, it was believed that the brain simply filtered the information that came in through the eyes, but now we’ve come to realize that it actually interprets it. That was the big news, but it was the ancillary finding that I think is far more fascinating, and relevant to our job of interpreting what we see in markets.
It turns out that the group of 3 Pac-Man shapes triggers less brain activity than the one all by itself, because triangles and circles are far more prevalent in the world than Pac-Man shapes. The single Pac-Man shape is unexpected and therefore requires more processing by our brain. In other words, if something is easy to explain, less brain activity is needed to process that information, compared to when something is unexpected or difficult to account for.
Our brains are efficiency experts (read: lazy), and as a result, we will attempt to create order as quickly as possible, using whatever shortcuts are readily available. What is odd is that it can easily produce two simultaneously held beliefs that are in direct opposition to each other. So long as each belief is confronted separately, the mental stress that comes with cognitive dissonance can be avoided, even for an entire lifetime.
So why do I bring this up now? The S&P 500 has dropped 7.3% from its highs. Oil is off 27% from its 2014 highs. UK inflation surprised the markets today by printing its lowest level since ’09, and European harmonized inflation hit 0.4%. These three Pac-Man shapes form what appears to be a triangle of sluggish growth, and confirm the consensus view in favor of a lower EUR and GBP versus the USD. Or does it?
While today’s data does in fact support the call for a more dovish Europe, all of the price action should also dampen the expectations for a more hawkish Fed. Although the USD rallied after the inflation print, the ratio of returns on 2y swaps in the US vs EU, one of my favorite indicators for predicting EUR/USD direction, had a fairly significant move in the other direction over the past week. In fact, US treasuries across the board have seen a significant lurch lower in yield since the last Fed meeting. What I’m getting at is, just because the three Pac-Man shapes exist and to look at them independently would require more brain activity, doesn’t mean a triangle actually exists.
In the summer of 2012, I began writing about and positioning for a return to long run equilibrium in commodities, particularly in ags and energy. The call had absolutely nothing to do with growth rates or cyclicality, and everything to do with the historic urbanization / industrialization project orchestrated by the Chinese, having turned the corner. I can’t emphasize enough, just how big this is, especially when you consider how little attention it is garnering and the impact it is having.
I feel a little odd suggesting that the steady decline in commodity prices that we’ve seen so far (which I believe will continue) should not be used as evidence of a slowing global economy. Truth is, I do believe growth in the global economy, including the US, will continue to be sluggish. However, lower commodity prices should not be seen as evidence of that. Quite the opposite actually. If the economy has any hope for a real shot in the arm, it will be the sudden availability of disposable income afforded by lower food and gas prices.
That brings me to Pac-Man #2. Inflation will continue to be limited because its drivers are non-existent. Lower commodity prices push down, but so to does very poor employment growth, yes even in the US, which continues to keep wage pressure in check.
How about Pac-Man #3, the equity sell-off? While it may fit the pattern that creates the triangle, I believe it’s merely coincidental. The equity rally has, and will continue to be, a function of excess liquidity sloshing around the system, in the hands of a very few, who refuse to invest it in the real economy. Here’s the caveat: what I’ve just described is, fundamentally, a bubble. That doesn’t mean it’s overvalued. What I do mean is that the investment in equities is not necessarily based on the expectation of higher growth or greater earnings, but merely serving as a destination for wealth that has no place else to go. (A similar case could be made for real estate.) What does it all mean? For those who are hoping for some radical move in markets and a sustained shift higher in volatility, stop reading. What I’m suggesting is that what we have been experiencing for the past 4 years, will continue for many more to come. Commodities lower, rates low, volatility low (except for the occasional, limited spike), and equities continuing to ratchet higher. Which of those am I least confident in? The equity call, because equities aren’t a true macro asset class. Price action is a function of herd activity. According to Bloomberg, the current P/E ratio for the S&P 500 is 17.2. Is that high, low or just right? The reality is, it’s impossible to answer. If it goes to 12.91 like it was at year end 2011, the index would be at 1408, or 25% lower than today’s close. If it were to trade at a P/E of 26.6, like it did at the end of 2001, the index would be 55% higher than today’s close. That’s a wide range for it to trade within, without any serious outlier change in macro fundamentals, but so long as that excess liquidity is sloshing around, I wouldn’t bet against equities.
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis and Behavioral Investing in the College of Engineering at the University of California. His book, AlphaBrain, is due to be published in early 2017 (Wiley & Sons).
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
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