Inside the Mind of a Crowd

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John Maynard Keynes once wrote what may be one of the most insightful observations on financial markets ever conceived:

We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth, and higher degrees.

Now, what exactly is he talking about?

While it sounds like Keynes may have been practicing some rare form of martial arts, or Zen meditation, he was actually talking about financial markets … in particular, how to predict them.

Read Leading Indicators Not Suggesting Imminent Market Peak, Recession

Most subscribers are probably familiar with the old “Newspaper Beauty Contest” story. If not, you can click here for a longer description, but here’s the gist:

A newspaper would run photographs of beautiful women and ask readers to mail in a ballot with their choice of which girl was the prettiest. Those who picked the girl that received the most votes would be entered into a drawing for a prize.

The decision-making hierarchy for submitting an entry to this contest goes like this:

- First-degree reasoning: “I think this girl is the prettiest, so I’ll pick her.

- Second-degree reasoning: “I think that most people will find this girl the prettiest, so I’ll pick her.”

- Third-degree reasoning: “I think that most people will think that most people will find this girl the prettiest, so I’ll pick her.”

At each higher level of this reasoning hierarchy, decision making and forecast accuracy improve. Why? Because winning the contest is not about the attractiveness of the women, it’s about anticipating crowd behavior. And that’s exactly what we must do in the financial markets to be successful investors.

Here’s another quick example to drive this point in: What would be more advantageous to you as a holder of Apple shares? A blowout earnings report? Or increased belief by institutional investors that Apple shares are undervalued?

While a strong earnings report could send the stock higher, it could also result in a sell off or no move at all if those earnings were already priced in. That is … it’s all about how the crowd interprets those earnings. On the other hand, an increased belief by institutional investors that shares are undervalued would likely lead to a rise in the share price as it implies there is value to be captured.

In this case, owning Apple shares because of a blowout earnings report is a first-degree decision – “I think Apple posted great earnings so the stock should move higher.”

Buying Apple shares because you think institutional investors believe Apple is undervalued is a second-degree decision – “I think that institutional investors will find that Apple shares are undervalued, so the stock should move higher.”

Now, can you determine what third-degree decision making would look like in this situation? At that level, our concern would focus on whether investors collectively believe that other institutional investors believe that Apple shares are undervalued …

As you can see, it’s really all about predicting what the crowd thinks the crowd will do. If you can frequently adopt this mindset, it will improve not just your investing, but many areas of life.

Moving on, over the last few decades the amount of data available to investors has increased exponentially. Typically, this data is broken down into “hard” and “soft” components.

Hard data looks at quantifiable economic reports such as the number of new jobs created each month or the growth in real GDP. Soft data, on the other hand, refers to reports that are based on sentiment, which try to capture how market participants “feel.”

Personally, I’ve always had a bent towards the hard data, and have been inclined to discount soft data based on my perception that people are often whimsical and inconsistent. I’ve also studied enough statistics to know that a small sample size doesn’t always represent the larger population.

But lately, I’m beginning to wonder if I’ve been on the wrong side of this argument. In line with the concept of first, second and third-degree thinking, I’m beginning to wonder if more emphasis should be placed on sentiment indicators as opposed to hard data. After all, it’s really not the economic data that influence asset prices, it’s the crowd’s reaction to that data … which is influenced heavily by their perceptions (i.e. sentiment).

To be clear, sentiment indicators have been a reliable source of market moving information for quite some time. Average consumer expectations for business conditions is actually one of the 10 components of The Conference Board’s Leading Economic Index. Two other prominent and widely watched measures of sentiment are the Consumer Confidence Index (also put out by The Conference Board) and the University of Michigan Consumer Sentiment Index.

We’ll take a look at each of these momentarily, but first, it may be beneficial to review one chart that has been circulating for quite some time. The chart below demonstrates the recent divergence we’ve seen between hard and soft data. Notably, measures of consumer sentiment have risen dramatically post-election, while hard data has not.

indexes hard soft data

Before we dig into this discrepancy, it’s worth pointing out that both hard and soft economic data have substantial predictive power when it comes to anticipating future economic activity. We can see this in the chart above by noticing the sharp declines in both data sets prior to the onset of each of the last three recessions (gray vertical bars). Also note that during expansions (periods in between the gray bars) we see a positive bias to both data sets, implying improving conditions.

While the delta between hard and soft data ballooned in recent months, it has since come back down to earth. This next chart shows the University of Michigan’s Consumer Sentiment Index. As you can see, sentiment has fallen back down to close to where it was during the November election.

index consumer sentiment

Consumer confidence saw a rebound last month, but it too has fallen back from peak levels.

US consumer confidence index

Now let’s get to the question at hand, which is – When hard and soft data diverge, as they have recently, which data set should we put more emphasis on?

This is a great question and in full disclosure, I don’t know; but I’ll venture an educated guess and tell you how I’m inclined to interpret this divergence.

First, let’s make sure we’re all on the same page in understanding that hard data is widely emphasized in most macroeconomic forecasting models. When you look at a GDP forecast or read the Fed’s beige book (which is chock full of tasty intellectual morsels), you’re dealing primarily with hard data.

This hard data has a long and proven track record for being able to predict future economic conditions with a decent degree of accuracy. Over the long-run, our economy tends to track this hard data in a “sum of the pieces” type fashion.

But what about in the short-run? And what about with regard to asset prices, which are much more capricious in nature than economic growth?

This is where I believe sentiment data really shines. As I’ve said many times, even with algorithmic investing on the rise, buy and sell decisions in the marketplace are still predominantly made by individuals. These individuals are subject to the same emotions and behavioral biases that impact all of us. And they result in a market that trades on changes in psychology.

So here’s my takeaway: Hard economic data takes precedence in the long-run. Over longer time periods, hard data will provide a better forecast of economic growth. In turn, because stock prices track corporate profits over the long-run (which are heavily levered to economic growth), stock prices will also tend to track hard data over the long run.

But on a shorter time frame, I believe that sentiment takes precedence. Investors typically make buy/sell decisions based on how they feel at any given moment, and this can be characterized by changes in sentiment and confidence indexes.

As an example, consider what’s happened so far in 2017. While hard data has remained subdued, confidence and sentiment spiked. And what happened to asset prices? They rose substantially, in line with sentiment.

But as we can see from the prior two charts, confidence and sentiment have come down recently, so what does that mean for asset prices moving forward?

If I had to venture a guess, which technically I do, since that’s my job, I’d say that we’re likely to see a short period of flat to marginally lower prices ahead, commensurate with the decline in sentiment. But, since hard data continues to suggest that this economic expansion continues in the background (albeit at a slow pace), any decline is likely to be modest and met with an inflow of buyers.

At this time neither hard nor soft data suggest that a recession is imminent, so there’s a good chance the bull market will keep chugging on. When we see both hard and soft data begin to trend downward, that’ll be a key indication that the winds truly are changing and it may be time to readjust our sails.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.

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About Matthew Kerkhoff