Mean Markets and Lizard Brains

by Terry Burnham

  The Loneliest Man in San Diego

  One of our human limitations is the desire to conform to the majority. This seems to be something built into us and it works against us since popular investments tend to be unprofitable.

  I learned something about this a few years ago at a football game between my Detroit Lions and the San Diego Chargers. My Lions lost the game, which was not surprising, as they’ve had a long tradition of mediocrity. What was surprising was the level of pain that I felt. The game was played in San Diego, and I was almost the only Detroit fan in a sea of Charger fans. The pain of losing in this setting was far greater than any I had experienced in home losses.

  The human desire to conform to those around us extends beyond sports stadiums. A line of psychological research performed by Professor Solomon Asch and others demonstrates the pressure to conform.22 In one setting for this research, six people enter a room and are asked to answer a question for which there is a clear answer. For example, here is a reference line:

  Which of the following lines matches the length of the reference line?

  Of the six people answering the questions, five are “confederates” of the experimenter, which means they give false answers designed to manipulate the behavior of others. In this case, the experimenter first asks the confederates to rate the lines, and they all give the same wrong answer. In this case they might say, “Line C matches line X.”

  After the five confederates have made these obviously false statements, the sixth person (who is not in on the experiment) is asked the same question. Now this person faces a bit of a quandary. Should he or she pick the obviously correct answer (A) or pick the same answer as everyone else (C)? In the original experiments, 75% of subjects sometimes conformed to what is labeled the “false consensus” by picking the obviously false answer (C).

  More recently, some of these original results have been challenged, but the basic finding seems intact. We seem built to want to be part of the crowd, even when doing so contradicts our direct observation.

  In the case of the lines, the correct answer is obvious. In the case of investments, the correct view is rarely so evident. Consider again the situation of eToys versus Toys R Us. While it appears obvious in retrospect that eToys would go bankrupt, imagine the pressure to conform. Day after bubble day, people (many of them professionals) bought the stock at high valuations. In such cases, our brains seem built to start believing what others are saying.

  To do well, an investor has to purchase exactly that which is unloved. This requires an ability to take the emotional pain of being different. I recall my broker’s mocking laugh when I placed an order to buy Treasury bonds in early 2000. Bonds had been going down consistently and all the “smart money,” he said, was selling, not buying.

  Unlike my Detroit Lions story, the bond story has a happy ending. As usual, the common consensus was wrong, and the bonds that I bought soon increased in value. The successful path was the path that was scorned.

  An Instinct for Losing Money

  A cartoon I saw posted over a trader’s desk on Wall Street read, “Definition of a quandary: Should I sit back and watch the market soar or buy now and cause it to plummet?”

  In some areas our natural tendencies take us to good outcomes. My wife’s recent pregnancy comes to mind as one such area. During the early part of pregnancy, the growing fetus is especially sensitive to certain naturally occurring toxins.

  According to Margie Profet, who won a MacArthur Foundation “genius” award for her work on this subject, pregnant women are built to avoid foods that include fetus-damaging toxins (teratogens).23 She provides evidence that pregnant women are nauseated by such foods, particularly cabbage-family vegetables like broccoli and cauliflower that have high levels of damaging compounds. If Profet is correct, then in the area of food choice, pregnant women ought to follow their instincts and eat whatever tastes good.

  When it comes to investing, the message is exactly reversed. The trades that feel good tend to lead to losses. For example, my older sister Sue recently sent me an e-mail saying, “I have gone crazy buying stocks! . . . No informed rationale for purchases, just a feeling. Reminds me of the slots at Vegas!” Sue’s lizard brain was screaming at her to buy.

  After almost a year of watching the market rally with only a small ownership in stocks, sister Sue was fed up. It was time for her to get in on the gravy train. Unfortunately, this impulsive purchase was timed for losses. In fact, within a few weeks of the e-mail, the stock market had its biggest decline in a year.

  My buddy Doug had a similar experience recently. Doug appears in a few chapters of this book and has had excellent results overall (in the stocks chapter, you can read about the day he earned $500,000 in an afternoon of surfing). In early 2002, Doug did some careful analysis of a few firms that he knew well. He decided to buy some Nortel stock at around $1 a share. This turned out to be a great purchase as the stock went up steadily.

  In the months after Doug’s purchase of Nortel, I heard not a single peep from him about his successful investment. Then one day, the following note arrived with the subject line of “a little bragging.” It read, “I was pushing Nortel big back at around $1. Well Nortel is over $8 today; up $1. Call me Warren :-)”

  After months of watching Nortel stock climb, Doug’s lizard brain made him send this e-mail at this particular moment. A Wall Street cliché is that “nobody rings a bell when it’s time to sell,” but this bragging e-mail was a perfect time to sell. Within a short period after the e-mail, Nortel’s stock returned to $3, going down even faster than it had risen.

  The message is that unfettered emotions are not the investor’s friend. Doug’s decision to buy was driven by analysis in his prefrontal cortex; his decision to gloat, by his lizard brain.

  A recent study documented the physiological reaction that people have to market information. Professor Andrew Lo and Dmitry Repin wired up a group of professional traders. 24 With a setup not too different from a heart stress test, these MIT researchers were able to measure minute changes in body temperature, skin conductance, and a host of other variables. The traders they wired were trading real money for an investment firm.

  What happened to our wired traders when news broke? Lo and Repin report two interesting findings. First, all the traders—even the most experienced—had measurable emotional responses to news. Second, the more experienced traders had weaker emotional responses than their less-experienced colleagues.

  These physiological responses may help us understand mean markets. When people see stock price changes or read about world events, we have physiological responses. If we act on those emotions, we tend to make precisely the wrong moves. In other words, we need to shackle the lizard brain in order to make money.

  To be successful we have to damp down our emotional response (toward the lower response of the experienced professional traders in the MIT study) or we need to prevent our emotional reactions from impoverishing us. The “timeless tips” of Chapter 10 focus on ways to shackle the impulsive and unprofitable lizard brain trader who lurks inside us.

  A Guide for Bubble Hunting

  As the title would suggest, The Incredible Shrinking Man portrays the life of a person as he goes from normal size to tiny. As the protagonist continues to shrink he faces danger from a house cat and—when even smaller—from a spider. Eventually, our hero realizes he cannot cower indefinitely. He confronts the spider, and even though the beast is much larger than the shrunken man, he kills it with a pin. After this victory, the movie ends as our hero prepares to leave his former house with a cocky walk and a blood-covered weapon slung over his shoulder.

  Similarly, we reach the end of the first section of this book and push off into a dangerous and unknown future. The science of irrationality has proven that people make a variety of errors. Furthermore, markets do not always iron out those errors and people sometimes stampede into and out of markets at precisely the wrong time. Markets can indeed be mean, but because markets
can be crazy, opportunities exist for profitable investments.

  While markets are irrational, the profits are hard to obtain precisely because $100 bills persist in the lizard brain’s financial blind spots. Just as we must use a mirror and other tricks to see into the blind spots on our cars, we need help to spot market opportunity. We have one tool so far and that is sentiment. We know that in order to make money, we must make the unpopular moves and attempt to constrain the lizard brain.

  PART TWO

  The Old Art of Macroeconomics

  We ended Part One with the conclusion that both individuals and markets are far from rational. Thus, the answer to the Mean Markets and Lizard Brains question of, “Where should I invest my money?” varies depending on the circumstances. Sometimes the conventional wisdom of stocks will be correct, but sometimes other investments will be better bets.

  Part Two sets the macroeconomic stage for choosing investments. Because markets can be far from rational, we cannot assume that prices are fair. Rather, we need to evaluate the prospects for bonds, stocks, and real estate. This section analyzes the fundamental forces that drive investment returns.

  Chapter 4 presents an economic snapshot of the United States. Will government deficits hurt the economy? Can the productivity revolution allow us to be richer and lead better lives? Chapter 5 examines the prospects for inflation and deflation. Is the Federal Reserve creating inflation? Why would anyone worry about prices being too low? Chapter 6 looks at the U.S. trade deficit and its implications for the value of the U.S. dollar. How will the decline in the U.S. dollar affect investors? When will the dollar decline end?

  chapter four

  U.S. ECONOMIC SNAPSHOT America the Talented Debtor

  Financial Hangover versus the American Spirit

  “It was the best of times, it was the worst of times.” So wrote Dickens in his famous opening to A Tale of Two Cities. Dickens continues with, “it was the age of wisdom, it was the age of foolishness, . . . it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair.”

  Dickens intended that this description be applicable to all times. And, not surprisingly, his sentiments provide a good summary of modern times, both generally and economically. In this chapter we examine competing arguments regarding the U.S. economy. In one camp are the worst-of-timers—the doom and gloomers who predict a financial hangover that will last for years or decades. On the other side are the best-of-timers—the bright-eyed new-agers who predict a magical world filled with material abundance and leisure.

  Revolution lurks just offstage throughout A Tale of Two Cities. The story begins in 1775, and Dickens’ readers knew that by the end of the century the streets of Paris would run red from the reign of terror. Revolution also lies at the heart of the debate about the modern economy. While the current revolution is less bloody than that experienced in eighteenth-century France, it is no less fundamental.

  The Industrial Revolution loosened the connection between physical labor and economic wealth. With machines we no longer needed to work like animals. Even with machines, however, we still needed to work. Now the information technology revolution promises material luxury without work.

  Even though he had never seen a computer, the famous economist John Maynard Keynes summarized the optimistic view in his 1930 essay, “The Economic Possibilities for Our Grandchildren.”1 In it Keynes looks forward to a materially rich world filled with leisure. He imagines that his grandchildren will have so much abundance they will work very few hours and spend the rest of their time on artistic and intellectual pursuits. In fact, Keynes worries about the lack of work to fill the day:

  we shall endeavor to spread the bread thin on the butter—to make what work there is still to be done to be as widely shared as possible. Three-hour shifts or a fifteen-hour week may put off the problem [of too little work] for a great while. For three hours a day is quite enough.

  If such a world is to exist for our grandchildren, information technology seems destined to play a major role.

  Published in 1859, A Tale of Two Cities contained a cautionary tale. It warned that those who do not prepare for change well might end up at the wrong end of a guillotine. Specifically, Britain had to be careful to avoid the bloody aspects of change that befell (and beheaded) French society.

  Similarly, the specter of the Japanese economy hangs over the United States. In the late 1980s, the Japanese economy was surging and analysts confidently predicted future greatness. Over the last 15 years, the Japanese economy has stagnated, unemployment has risen dramatically, and confidence has waned. Japan still leads in many economic categories, but also has a suicide rate that is among the highest for industrialized countries.

  So what path will the United States follow? Will it be Keynes’s vision of examined leisure created by information technology, or will we stumble down a painful path similar to that taken by post-bubble Japan?

  We will develop the answer to this question throughout this chapter. To understand the problem we will have to wade knee-deep in economic statistics of debts, deficits, and productivity. When I ponder the U.S. economy, however, I do not think only of economic data. In addition, I think often of a high school classmate of mine—Steve—and his behavior in the fall of 1975.

  In 1975 I was a junior in high school on a mediocre cross-country running team. Actually, both the team and I were mediocre—so bad that our archrivals and state champions, Grosse Pointe North, used our competitions as practice days. Rather than drive to our competitions, “North” would run eight miles just to get to the starting line. They’d then run the three-mile race, defeat us handily, and run the eight miles back home. They didn’t want to waste a training day by running just a few miles against such a pathetic team as ours.

  Into this gloom came the “new guy,” Steve, a young man with a great natural talent for running. Although he had not been on the team in previous years, he showed early promise and soon became the best runner on our team.

  The funny thing about Steve, however, was that he didn’t sacrifice much to be a great runner. While my friend Jim and I made sure to eat right and go to bed early, Steve was not averse to having a few drinks the night before a competition. He would even sometimes arrive at a Saturday morning race hungover, his natural talent usually allowing him to outrun the rest of us. Though on the mornings after particularly hard evenings, we were not sure whether Steve’s talent or Steve’s hangover would prevail. Had the excesses of the previous night been extreme enough as to overwhelm Steve’s ability?

  The U.S. economy faces a similar battle between hangover and talent. The United States has demonstrated an unmatched ability to innovate and produce. Our economic system seems to have a natural talent for making products both cheaply and well. Impeding that talent, at least over the next several years, is the financial hangover caused by the excesses of the 1990s.

  What condition will win out? The hangover or the talent? To find out we’ll delve into some macroeconomic issues. When I was an MBA student at MIT, the economist Lester Thurow said, “If you like reading [dry] data tables, then you should consider becoming an economist.” The shoe that Lester described fit me perfectly; after a few years I returned to get a Ph.D. and became an economist.

  When I tell people at social functions that I am an economics professor, a very common response is, “That was my worst course in college.” I have met literally dozens of people who took one economics course, found it distasteful, and stopped. Part of this dislike of economics comes from the standard teaching style (boring!), but part is due to the very nature of the subject (including dry data tables). As hard as it is for me to understand, I have learned that some people do not enjoy reading economic statistics.

  Furthermore, some people can succeed financially without studying economic numbers. Take my friend David who works as an oil trader in the New York Mercantile Exchange. He does his trading in a crowd on the floor of the exchange—just like the people
shown screaming at each other on TV and in movies, David makes his living by buying and selling oil. In fact, David once joked that his epitaph ought to read, “He yelled for cash.”

  David’s yelling has resulted in quite a bit of cash. His lifetime earnings are north of $10 million, and he has earned more than $1 million in some years.

  How does David make his money?

  In the early days of trying to figure out David’s secret, I used to grill him. “Do you think that the United States will start constructing new nuclear power plants and thereby reduce demand for oil? How did the 1991 oil fires set by Saddam Hussein’s troops affect the future capacity of Kuwaiti production?” To all of these questions, David would calmly answer, “I do not know.” He even joked that to make money he wouldn’t even need to know the number of gallons in a barrel of oil (42).