Things That Make You Go Hmmm...

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pavlovSometimes the stars just align. The beautifully bearded gentleman on the left was born on September 14, 1849 at Rayazan, in Central Russia to a village priest called Peter Dmitrievich Pavlov. After being educated at the church school, Ivan Petrovich Pavlov entered the theological seminary, destined to follow his father into a religious career, but, inspired by the ideas of D.I. Pisarev—Russia’s pre-eminent literary critic of the 1860s—and I.M. Sechenov, the father of Russian Physiology, the young man turned his back on the church and decided that mathematics and science were his calling.

He became fascinated with physiology and demonstrated a significant aptitude for the science of the function of living systems—so much so that he was awarded a gold medal and a fellowship by the Academy of Medical Surgery where he conducted research under the famous Russian Clinician S. P. Botkin.

In 1890 Pavlov was appointed Professor of Pharmacology at the Military Medical Academy and five years later he was appointed to the then vacant Chair of Physiology, which he held till 1925. It was during this time that Pavlov conducted a study that would become famous the world over and elevate him to the ranks of those rare men and women for whom a new adjective is coined:

Pavlovian [pævˈləʊvɪən], adj

1. (Psychology) of or relating to the work of Ivan Pavlov (1849-1936), the Russian physiologist

2. (Psychology) (of a reaction or response) automatic; involuntary

Pavlov’s experiment was in what became known as Classical (or Pavlovian) Conditioning:

(Wikipedia): Classical conditioning (also Pavlovian conditioning or respondent conditioning) is a form of learning in which one stimulus, the conditioned stimulus or CS, comes to signal the occurrence of a second stimulus, the unconditioned stimulus or US. The US is usually a biologically significant stimulus such as food or pain that elicits a response from the start; this is called the unconditioned response or UR. The CS usually produces no particular response at first, but after conditioning it elicits the conditioned response or CR. Classical conditioning differs from operant or instrumental conditioning, in which behavior emitted by the organism is strengthened or weakened by its consequences (e.g. reward or punishment).

Conditioning is usually done by pairing the two stimuli, as in Pavlov’s classic experiments. Pavlov presented dogs with a ringing bell (CS) followed by food (US). The food (US) elicited salivation (UR), and after repeated bell-food pairings the bell also caused the dogs to salivate (CR).

In short, by associating the sound of a ringing bell with the appearance of food, Pavlov conditioned dogs to salivate merely at the sound of the bell.

For many years, this classical conditioning has been prevalent across financial markets the world over but, while its prevalence cannot be doubted, it has remained unobtrusive for one reason and one reason only—it has worked almost flawlessly. On Wall Street, however, no successful idea was ever an orphan and so classical conditioning’s fruits were passed off as those of heightened intellect amongst the great and good of the financial world.

This classical conditioning can be broken down into a grid which I will simplify enormously for the purposes of our discussion today:

buy sell 10 jun 2012

Over the last 27 years of watching the technological means of delivering financial information improve in both quality and speed, one thing has remained constant and that is the Pavlovian reaction of markets to various economic conditions, data releases, natural disasters and, lately, Black Swans.

When the economy is booming and greed is in the ascendancy it is all about making the big killing. Equities and commodities are the only games in town. It is ‘Risk On’.

When the tables are turned and we find fear and loathing in the air amidst weak growth, then nobody wants to know about anything but the safety of bonds and precious metals.

Do NOT let the abscence of long lines of elegantly-clothed and behatted men and women queuing for soup fool you. The world—your world—has changed.

But market ‘reactions’ are strange birds indeed.

Think about it: on an individual basis, if a payrolls number (subject to all kinds of after-the-fact revisions) misses, what do people do? They ‘sell the ‘equity market’ and they buy the ‘bond market’? Why? Is it because at that precise moment the world is suddenly worse than it was two seconds earlier? Is it because they have taken their time to look into the report, analyze the various metrics that make up the headline number and decide upon a course of appropriate action? No. They ‘sell’ and ‘buy’ the respective ‘markets’ because that is what they have been conditioned to do and that is what they subconsciously know that everybody else has been conditioned to do’ (though I will concede that anyone positioning themselves ahead of a number in anticipation of a market reaction to a specific number and getting it wrong has a valid reason to move swiftly).

If payroll numbers are down, does that mean Johnson & Johnson is instantly worth less? If it is the beginning of a long and large increase in unemployment, perhaps, but selling ‘the market’ on a bad number is a Pavlovian response.

Selling ‘the market’ on bad news for a particular asset class is the expected reaction and so the desire to either conform with the pack or, more likely, to try and get ahead of it, drives an instant investment ‘decision’ and, in my experience, the words ‘instant’ and ‘investment’ are two of the most mutually exclusive terms in the English language and ought to remain so.

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