![feedback](http://thereformedbroker.com/wp-content/uploads/2015/08/feedback.jpg)
The rat runs left and reaches the cheese. He is rewarded by the maze. Guess which direction he runs the next time through. And the next. And the next.
Run left, get cheese. Run left, get cheese.
Another rat is dropped in and proceeds to run right. No cheese. He gets an electric shock instead. Guess which direction he never runs in again.
Don’t go right, don’t go right, don’t go right motherf***er…
In an uptrending market, investors are conditioned to hold onto their investments and buy more because it continues to reward them. This is true for real estate, commodities, venture capitalism and, of course, the public markets. I buy stocks, they go up, it feels good, I buy more stocks, they go up, it feels good, I buy even more stocks, they go up, it feels good…
The longer this goes on for, the more ingrained the conditioning. Tentative dip-buying gives way to confident leaps into the breach. This is why the dips become short and shallow while the recoveries become v-shaped. No time to lose!
But then, slowly, the instant gratification begins to subside. It is imperceptible at first. They’ll bounce back, they always do! But they stop bouncing back. The positive feedback loop breaks down. I buy stocks, they don’t go up, I buy more stocks, they sink lower…
This is when the first wave of doubt sets in and the conditioning wears off. There are less buyers coming in because the reward is no longer instantaneous. Where’s the cheese?
Peaks are formed in a given investment market as the realization slowly dawns that the good feelings are not automatic anymore. They say that bottoms are an event (no one left to sell!) and tops are process. They’re right. Which makes the term “peak” itself a misnomer. Markets top in a hill formation – a gradual course of persistently lower highs alter the slope of the market and round it downward as investor enthusiasm fades.
One of the least understood things about the stock market crashes of 1987 and 1929 is that they did not begin from all-time record highs. They each happened several weeks after record highs had been established. In ’29 the Dow Jones topped out during the week before Labor Day. The months of September and October went by in a sort of suspended animation – investors bought more stocks but the automatic gains – the instant karma – of the prior few years failed to materialize. Where’s the cheese?
The rest is history.
In the case of 1987, the Dow Jones hit its high in late July and then for weeks and weeks investors sat there wondering where the reward was for their latest purchases. There wouldn’t be a reward. It was an electric shock instead, occurring ten weeks or so after the positive feedback loop ceased to hold up its end of the bargain. I buy stocks, they go up. I buy stocks they go up. I buy stocks they…wait a minute, what gives? This thing isn’t working right anymore.
I use the examples of ’87 and ’29 not because I believe they are a good analog to now, but because they are extreme examples and highly illustrative of the breakdown in conditioning. The automatic, predictable gains stop showing up and confusion sets in. And then frustration. Finally, fear.
Which brings us to the present. The S&P 500 sits just a few percentage points from its all-time record high. And although we’re elevated, it is important to note that the major averages have made no upward progress since Thanksgiving 2014. This after years of compound annual returns of around 20%. We haven’t fallen, but with every passing week, more and more investors are asking themselves where’s the cheese?
Beneath the surface, there is a very different picture forming. The average S&P 500 stock is down 15% from its 52-week high. The positive feedback loop has been broken across vast swathes of the US stock market. Energy, Materials, Utilities, Technology, IPOs, REITs, Small Caps – one by one, our hearts are broken. The feedback is all negative. I buy stocks, they go down. I buy more stocks, they go even lower. Shock, shock, shock.
What is a rat to do? Can’t run left because there’s no cheese anymore. Can’t run right because it hurts. Fear sets in. Fear leads to anger, anger leads to hate, hate leads to suffering.
We’re not quite there yet. There is real fear but the anger part hasn’t manifested itself. Although the individual losses are piling up and the gains in the overall market are failing to offset them, it is far from resolved.
The positive feedback loop can be restored if and when the plunge in the advance-decline line, highs-minus-lows index and the drastic dispersion between S&P 500 sectors reverses course. But there are no signs that this is yet happening. And the longer we go without a positive feedback loop as backdrop, the more susceptible we are to a downtrend. Which introduces a feedback loop all its own when it arrives. I buy stocks, I get shocked. I buy stocks, I get shocked. I stop buying stocks, I don’t get shocked…
The maze is closing in on us.
[…] separated the men from the boys, the ladies from the girls. I think we’re in it, now that the positive feedback loop has totally broken down. The Russell 2000 is now flat over the last 18 months with nothing but chop to show for our […]
[…] Josh Brown hit the nail on the head this weekend by writing how the feedback loop of the market is no longer positive… The rat runs left and reaches the cheese. He is rewarded by the maze. Guess which direction he runs the next time through. And the next. And the next. Run left, get cheese. Run left, get cheese. Another rat is dropped in and proceeds to run right. No cheese. He gets an electric shock instead. Guess which direction he never runs in again. (TheReformedBroker) […]
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