THE RECENCY EFFECT – 2011 IS NOT 2010
The data miners are out in force in recent weeks trying to compare 2011 to 2010. We’re seeing endless chart overlays with excessively simplistic analysis that says 2011 = 2010 because of XYZ. In the world of cognitive science this attempt to compare everything to recent events is called the recency effect. It’s particularly pervasive in the stock market as we are always attempting to decipher future events by past actions. We have a tendency to believe that the market’s recent actions are likely to repeat themselves even though the market is a dynamically adapting non-linear system. You see it on a daily basis in the markets. The only problem is that it will almost always lead you astray.
Understanding the past is vital in building a sound understanding of macro trends. After all, Mark Twain was right when he said that history may not repeat, but it does tend to rhyme.* And when it comes to big broad macro trends that is particularly true. I’ve utilized the Japan playbook for much of my understanding of the current economic environment. And it has worked. The problem is, this doesn’t always translate into an ability to understand where the market is going. The market after all, is not the economy.
The reason why this recency effect is likely to lead you astray more often than not is due to the fact that markets are just a microcosm of the global economy. Therefore, understanding what the market did in 1937 during the Great Depression is not likely to help you decipher what the market is going to do in 2011. Why? Because the micro picture is entirely different. There might be similarities between the two environments and you might be able to glean very valuable insights from the macro picture by understanding what occurred in 1937, but the equity market of 2011 in no way resembles the equity market of 1937.
The same can be said of the recent attempts to compare 2010 and 2011. The primary problem with these comparisons is that they are not apples to apples. Instead of in-depth analysis we are generally seeing YTD charts with labels such as Jackson Hole, the recent sell-off and an emphasis on the spectacular year-end rally in 2010. The thinking here is even more simplistic than that though. Investors utilizing this comparison are prone to believe that the Fed is able to once again save the equity markets via a policy response. But this assumes that the market is not dynamic, not adaptive and linear – things it is not!
The problem here is that the market environments are entirely different and the lessons of the past have now been built into investor behavior in a fashion that actually makes the current system even more dynamic than it was in the past. And we see this difference in many other markets which are confirming that this is a different animal from 2010. Whether it be high yield bonds, CDS price action, sovereign debt markets, interbank lending markets, etc. They are all telling us that the credit markets are FAR more strained than they were in 2010. The animal we think we know in 2011 is far more concerned than the one we knew in 2010. And that alone makes this a very different beast. And while it doesn’t hurt to understand the creature of 2010, relying on it to behave the same exact way it did last year is likely to be misleading.
In sum, investors are prone to oversimplify their analysis by referring to technical analysis while combining this with recent events in order to try to explain the future market action. This recency effect, more often than not, is proven false when one looks under the surface and better understands the comparison and understands that the market is not a simple linear system. This recency effect leads investors to establish strategies and beliefs that are excessively simplistic and likely to fail. But if an investor better understands the complexities of the system and its ability to adapt and evolve, that investor can better prepare him/herself to conform to the changing environment and create a strategy that is more appropriate given the ever adapting marketplace. In short, adapt with the adapting market or die.
* Updated with proper Mark Twain citation.
Im hearing far more comparisons to 2008. I have not heard a single comparison to 2010.
I have a list of them. Didn’t name names because there’s no need to point out who is doing the shoddy analysis.
1. Do they read this blog ?
2. T2 (Tongue & Tilson) must one of them ( doing shoddy analysis).
I agree with CapitalObserver that there’s been far more comparisons to 2008 than 2010. Everyone is waiting for Europe’s Lehman moment. That some have made comparisons to 2010 doesn’t mean the recency effect doesn’t apply to 2008 also as it is still the far more traumatic even in people’s memory.
Excellent insight/analysis here Cullen.
You are absolutely right: Until a few weeks ago anyway, most of the yappers in the media were prattling on about how 2011 was looking bound to repeat 2010: Just hang tough through the summer “soft patch,” and look forward to the “land of milk and honey” waiting in the glorious “second half.”
BTW, has anyone looked at the DAX lately? If the US markets achieve similar levels, and why shouldn’t they, we are looking at S&P 1050, easy.
CR, vat can I say? A+!
Da’ same way european bailouts seem to have stopped working, the Benny put is out of steam.
The market is a wonderful beast. No system works at all times. In the long term term, fundamentals work. And that seems to be what rules the market now,
I am 70%+ cash now witn 5% NLY 15% TIAACREF RE ACCOUNT and 10% minor stuff; but wish I was 100% cash. With a 6.8% ytd return, I’ve met my 5% annual returb objective, but the greed devil in my steers me to the great risk opoortunities tgst seem yo have developed, mainly in the short side. However, what the CH FRANC did today suggests cash is king.
What the SNB dis today will remind people fiat currency systems are far from dead Expect gold weakness in the short term and possiblybeyond.
I’m collecting premium from options but doing weekly options mostly. And I think after the September maturity I’ll have a hedge on the downside and leave it there even if seems it’s gonna expire worthless.
I’ve sold pretty much all my AUD and put it in USD, expecting the rush to safety *when* Europe breaks itself to pieces.
Whenever I see people trying to justify opinion X with some overlaid chart or technical analysis, I think back to footage of BF Skinner demonstrating how a pigeon develops superstitious beliefs.
We’re so fast to see patterns even when they don’t really exist. To avoid this in my own technical analysis I ruthlessly backtest and discard a model as soon as it proves to be superstitious. I can only conclude that most technical analysis, when treated scientifically, is total nonsense. Even the reasonably “good” stuff is just a guide only.
The most successful strategy for me has been to monitor for the voices/datafeeds that move the market the most (which changes over time), figure out how they work (reverse engineer the psychology), and then try to predict them. At the moment, it’s the banksters and they’re scared of the bombs in their hands.
Cullen,
Absolutely true. In fact, I have been curious what the reaction to QE3 or Operation Twist or whatever will actually be should it occur. The commentary seems to be that it is desired by the market. However, it doesn’t seem that many in particular believe it was of any benefit, they just see 2010 and assume it will work the same way because everybody else will bid up assets. Keynes’ beauty contest at work. Except, now that market participants are more cynical about any such policies prospects I suspect the dynamics will be wholly dissimilar.
It took me more than two years to understand which indicators were important and which not by visiting (predominantly US and two canadian) websites like this one. And when I look at my indicators it’s clear 2011 – most definitely – does not equate to 2010.
E.g. My prediction for the balance of this year is that US interest rates are going (much) higher. And that will be the wrecking ball destroying the world economy.
Yes, the japanese situation after 1990 is very instructive but one MUST keep an open eye (and ear) for what’s different and what’s equal between Japan (e.g. after 1990) and the US (e.g after say 2007). E.g. Japan – like the US – had a real estate bubble. But for most folks in the US and in Europe that remained (far) below the radar because it didn’t have an impact on the rest of the world, unlike what’s going on now with the US real estate market.
Willy2
What are the Canadian sites you like?
I am interested in the Canadian view and would appreciate a good site rx.
Here’re some – IMO – good websites in North America I regularly visit:
In canada:
http://www.howestreet.com. Bob Hoye is my favourite.
http://www.jugglingdynamite.com
http://greaterfool.ca (Garth Turner). Yes Canada has a real estate bubble as well.
In the US:
Inflationistas:
http://www.financialsense.com. Mr. Jim Puplava has a very knowledge of the economic situation in the US but he doesn’t connect the dots correctly and therefore ends up being an inflationista.
http://www.jsminesite.com.
http://traderdannorcini.blogspot.com/ (he has from time to time excellent graphs)
http://www.dollarcollapse.com. Provides excellent starting point for other websites.
Deflationistas:
Mike Shedlock. (GOOGLE “”mish”")
Karl Denninger’s website: http://marketticker.org
Pragmatic Capitalism
And what will drive IR higher? I can only see them only flat to lower.
Mr. Margin !!! Speculators/traders have gone long these futures on leverage. But when Mr. Margin starts knocking on doors then those “”longs”" will have to be sold. The RSI for both the 10 and the 30 year T-bond are weakening in spite of those futures going higher. And that could/does signal a reversal is up ahead.
And when it doesn’t happen (as it continues to not happen), will you admit your understanding is flawed?
If margin or bond vigilantes is ever the reason for a rate hike, I’ll admit I was wrong.
He’s been banging this drum long enough here to already have been forced into several mea culpas…..
Done deal !!! I admitted already once I was wrong about the direction Treasuries were going. Had to cover my shorts twice. Then I went long for a short while. Regained some money but now I am on the sidelines. Waiting to go short again.
Willy,
Just responded to your other post in the other article. Apologies again if I seem to have been berrating you.
I’d be tempted to short bonds now as funds move out of bonds into stocks until we have another leg down in the market.
I will say this though, if we get sub 1% yields and in the next few years have a bout of inflation, I would not be surprised if bonds “crash” but not “collapse”.
But we need to define these subjective terms.
Also asking someone to say when we have a bond collapse or hyperinflation is like me asking you what year the the balance sheet recession end? The fact you can’t give me a date doesn’t mean it will not end does it?
“Also asking someone to say when we have a bond collapse or hyperinflation is like me asking you what year the the balance sheet recession end? The fact you can’t give me a date doesn’t mean it will not end does it?”
You and I went through this with Hyperinflation a while back. Your argument seems to makes sense on the surface, but it can be applied to a multitude of wildly unlikely things which convolutes the differences in probability and applicability of accurate analysis, and in doing so, misrepresents the true probability of the events by making a ‘common’ comparison of them both.
Comparing this to a prediction about the end of the balance sheet recession doesn’t hold water to me; the end of the balance sheet recession could be sped along by events that are uncertain to occur or not and if they did occur could have different magnitudes (but are significantly more likely than a Hyperinflation- which you said you put at a 1% chance of occurrence- or IMO US Treasuries collapse)
I could say, “asking someone to say when we will be invaded by an aliens is like asking me when the Fed will next decide to raise interest rates” Alien’s may never invade yet there remains a (minute) possibility. And although it is unknown when it will occur the Fed will raise interest rates when the economy starts to run hot enough again. I know my example seems obtuse and condescending but I chose it to show how my side of this discussion views the probability of the events being compared.
(WIlly, don’t mean to hound on you but this is the crux of the discussion) Willy has been calling, repeatedly and for long periods of time for something that has not occurred. This leads me to believe that his conclusions are wrong because either his analysis is wrong or his paradigm for analysis is flawed. No one has called the end of balance sheet recession because we haven’t seen what would justify that call! If I saw Obama come one TV and announce a FICA payroll tax holiday a la Mosler, we’d say ‘ok, we’re going in the right direction for fixing the balance sheet recession” and observe data going forward to see if we are correct. That data would either support our conclusion or not, we would be held accountable to accuracy of that call. WIlly has claimed repeatedly for the ‘bursting of the bond bubble’ or something similar and has historically been wrong.
I don’t comment here often, but I will say one of my good friends worked for the Federal Reserve Bank of NY. I asked him when interest rates would rise, his answer was after the 2012 election and only if the economy was improving. You can fiqure the rest on your own. Best of luck on your bond short. Sounds to me you’d be better to buy the dip in bonds.
I don’t like to mention it, but my uncle worked at the NY Fed for a long time and has intimated that the Fed can make the rate what they want. I still don’t understand Willy’s ‘leverage’ argument. It seems to be based on the idea that the Fed doesn’t have the control that it obviously does.
Is it considered denigration to point out that quoting Twain without referencing him is plagiarism?
I write 10′s of thousands of words a week. I make mistakes. So crucify me. Error fixed Mr. Danger. Thanks for the snarky comment though. Perhaps next time it would be more helpful to point out the error and ask me to correct it. That is of course, unless you think I am intentionally writing malicious content and ripping off famous authors (which I am pretty sure most readers know I wouldn’t do)….
Is it considered denigration to point out that attributing that particular quote to Twain is an act of intellectual laziness, as its source is contested and there is no actual evidence of Twain ever uttering those words?
http://www.freakonomics.com/2011/04/14/quotes-uncovered-youth-and-the-young/
How about “no good deed goes unpunished”. Give away a great deal of valuable information, provide a forum for commentary on that information, explain the same things over and over to the denser among us, and get called a plagiarist for using a public domain quote of uncertain attribution. It’s a lose-lose proposition, or perhaps TPC is a masochist.
A plus.
My vote is masochist, with excessive altruistic tendencies.
The quote you are referring too has become so common that I think it is ridiculous to reference it in most contexts. Most certainly there is no need for it in such a prolific blog.
Oh, for goodness sake, Danger.
Cullen, since you have a little Twain in you, you might pull this one by Twain out sometime: “It’s a damn poor mind that can’t think of at least two ways to spell every word.” (I’ve needed that one before).
Does the 2 ISM reports give more weight to the comparison? Both are expanding, some weak internals, Manufacturing downtrend and Service bouncing.
ALL I know, is that after 40+ years of professional trading (for myself), I learned decades ago to “treat the markets like beautiful woman and just follow them around.” …. and no, I don’t have a clue who said it first, nor care.
MMT to Obama- Use This Speech!
Posted by WARREN MOSLER on September 2nd, 2011
http://moslereconomics.com/2011/09/02/mmt-to-obama-use-this-speech/
Latest Hussman confirms 2011 ain’t 2010:
http://www.hussman.net/wmc/wmc110905.htm
I have been reading Hussman for some time. How does his economic view and his analysis fit with the MMT thinking. Although his fund has had a bit of a dry spell, I appreciate the extent of his data analysis. I admit being a novice when it comes to hedging portfilios and have come from a balanced buy/hold asset allocation style. After reading other points of view, I have adjusted to some of Hussman’s valuation metrics and allocated more to cash while waiting.for better long term potential returns. I wonder if this will help me have a better long term return. In the end, I am spending a lot of time trying to understand this macro econ in order to protect and increase a portfolio given a balanced risk profile.
I had a bit of an email back and forth with Dr. Hussman a few months back. Let’s just say he doesn’t subscribe to the MMT view.
His work is excellent though and incredibly useful.
“Hindsight is 20-20″, which is the mentality of many investors, however, its never the same the markets that is. Its the way the market works you are going to have winner and losers, if it was predictable we would all be rich. That’s why so many investors view the market with alot of trepidation, most I would imagine are petrified.
interesting analysis of 2011 vs 2010, and not a shoddy job at all: http://scottgrannis.blogspot.com/2011/09/20-bullish-charts-revisited.html
One may want to compare this year to 2007, since it also had a pre-election November and similar FX instability.
However, like the author mentions, past charts are great references but do not always indicate the future. They do, however, provide a great learning point of for what NOT to do, should the same scenario start to surface again. Imagine, just imagine, that central bankers have already thought of a remedy. Several factors speak to this possibility:
The overnight lending of Securities (about 10-12M all week vs.34000M+ before the market retracements of March and July)have been nominal, below the amount one would expect if we were on the brink of falling off a cliff.
The VIX has been manipulated by either selling or buying the Futures, and has not provided a true signal of liquidity, or the abcense, which is exactly what the FED intended. Perhaps they did not realize the VIX warns investors, including the little guy with something left in his trading book to live off. Perhaps the FED doesn’t believe the little guy trades. Anyway, beside the point. Let me continue my musings and argument that this time might be different although appear similar…
The decrease in Gold argues against a huge double dip, just take a look at today, Sept. 9, where the market is down 2-3%, the Euro falling against the Dixie. One would think Gold would rally, but it was trying to remain in the green, hanging on for dear life.
The SNB took care of Gold’s upward move, and the CHF inflation, by setting a floor to the Euro at 1.20
Central banks have also reigned in FX float to reduce the potential of mass selling, which is what drives markets up or down.
Interbank FX swaps also mitigate the currency risks, and swaps are active.
The ECB FX swap with the FED have not resumed with frequency, which is what one would expect: ECB sells bonds in Euro’s, swaps with the FED, the Dixie appreciates and the ECB buys back their own bonds in US Dollars. A great way t save some money. But, the swaps have been few and far between, indicating that the DX is not to appreciate in a grand manner. Although it did pop thru its 200 day EMA today. The dollar may be showing a sign of…health? Besides,9-9-11 is DX options expiration day. And the memorial of 9/11. Is there a better way to show the terrorists whom tried to destroy or financial systems the strength of the US Dollar? A great middle finger, A language that does not need translation.
The VIX: this indicator has peaked during the bottom of a valley when it’s buying time. It’s peaking right now.
So, head on out and buy some of the stocks going in to the Russell indexes, released this June.
Good trading to you all,
Zen