The Market is an Instinctual Beast

31 May 2012

I've been thinking about the behaviour of markets lately. While there is a theory of "rational markets," I don't think it can be defended.

Better Mr. Keynes' trenchant observation, "Markets can remain irrational a lot longer than you and I can remain solvent!"

Indeed.

Rather, I argue that markets are instinctual beasts.

Having had years of experience horseback riding in the Canadian Rockies, I can attest that the horse is a very instinctual animal. It is also unstoppable when under the immediate influence of instincts such as "fight or flight," "startle," or "running with the herd." As the average horse weighs a half ton, basically, you don't stand in the way of an instinctual beast that is many times your own weight.

So too, we should not stand in the way of the market when its instincts are triggered. You have to "go with" the market, though obviously we can "steer" by choosing where we place our investments!

Another image of the market as an instinctual animal references the seasonal instincts of the birds. Right now, the robins are building their nests. As I have about 300 trees surrounding my home, I'm seeing lots of robin activity, right now. A naive investor might therefore conclude that the best place to invest is in nest-building materials.

However, as the seasons change, the instinctual behaviour of the robins will alter as well. Based on my own experience, after nest-building comes the territorial defense of the anticipated, and then the newly-hatched young.

And of course, the seasons change again, as they do in their cycles, and soon enough, all of the seasonal brids will leave, flying south. Those invested in nest-building materials will experience a "bear market."

Then it shall be widely assumed by the market that, as robins no longer live here, robins simply aren't a good investment. Until, of course, they return the following spring. The instinctual beast does not think that far ahead!

And so it goes with the markets.

Bill Fleckenstein observed this week, "the market is playing checkers, not chess." It thinks ahead, but only in somewhat obvious ways.

My present take is that the markets have been in a so-called "risk off" mode since 1999-2000, which involves moving out of equities and into government and other bond instruments. (In fact, the original move to bonds occurred with the ascent of Paul Volcker at the Federal Reserve, as, due to his influence, the prime rate peaked at 21.5% in December 1980, though that is another story.)

Now it is no secret that inflationary monetary policy relies on low interest rates to enable the jugglers to keep all their bowling pins in the air.

Of course, when inflation is in vogue, debts accumulate, and ultimately, this undermines the foundation of the bond market, as investors grow concerned about inflation eating away at their investment (as governments rely on monetary inflation to make debt repayment "affordable").

Bond buyers then demand higher interest rates as a "risk premium." This is what's happening in Greece, Spain and Italy right now. But countries with printing presses are accorded continuing low rates, as we are all willing to pretend - for a season - that inflation is not real.

Now it is my prediction that the seasons of the market will change yet again - it would hardly be surprising to anyone with a historical view. I suggest further that with the next seasonal transition, the markets' instunctual responses will also shift - and dramatically so!

When the robins have flown south, bonds will be viewed as vulnerable to devaluation by inflation (it's already happening, as I've written many times, but we simply pretend it's not).

The "risk off" instinct towards bonds has prevailed for 12 years, with a seemingly solid 20-year foundation undelying the recent era of the dominance of bonds. But this season, too, shall change, as all seasons do.

Now, when the instintual behaviour of the market next shifts, what should we expect?. In my view, bonds will become the next "risky" asset, and investors will begin to flee them in droves, with bonds emerging as "the next bear market." Today's ultra-low, even record-low bond interest rates will prove unsustainable, just as did investing in the nest-building business.

So if "risk off" is the current instinct of the market, driven by the buying of the bonds of governments that print their own money, what then shall be the next instinctive market trend?

Well, bonds will remain in a bear market, probably for a very lenghty period. The stock market, already dead in the water for 12 years, is not set to recover any time soon.

My prediction is that the next season will be that of the treasure hunter - dominated by those seeking "security" through a search for value. The new treasure seekers will dig much more deeply than today's "risk off" traders, who have little more than herd instinct to guide them.

Where have treasure hunters always looked? You know and I know that the object of the treasure hunter is gold, and this is where the instinctive behaviour of the market will turn next.

So, my advice is to find your treasure now, by holding your savings in precious metals and in the stocks of companies that mine or derive royalties from precious metal production.

I wish successful treaure hunting to you all!
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