Operant Conditioning, Market Trends, and Small Bets: A 2012 vs. 2008 Case Study

In this piece, I’m going to examine the question: why do markets trend in the way that they do? Part of the answer, in my view, can be found in the process of operant conditioning, a process that we explored in the prior piece on the market-relevant insights of the great B.F. Skinner.  The capacity to understand and identify that process–as it plays out in us, and in the rest of the market–can provide opportunities for outperformance.

Why Do Markets Trend?

The fact that markets “trend”–or at least “trended” in the past–is a well-established empirical fact, confirmed in tests on different periods of history, different countries, different asset classes, and even different individual stocks.

The question is, why do markets trend?  Here’s a possible answer.  We know that market participants invest on the basis of a fundamental outlook, looking anywhere from a few months to a few years out into the future.  Rationally, it would make sense for them to look out farther, a few decades, maybe longer–but the fundamental picture that far out is too difficult to confidently estimate and too distant to want to focus on, particularly when near to medium term price changes will determine the assessment of performance.

Crucially, fundamental outlooks–for earnings, interest rates, credit, investment, employment, and whatever else is relevant to the asset class or security in question–move in trends.  An important example would be the business cycle.  The economy sees an expansionary period of rising investment, employment, output, profits, wages, optimism, and so on.  Imbalances inevitably accumulate in the process.  The imbalances unwind in the form of a recession, a temporary period of contraction in the variables that were previously expanding.  Historically, the unwind has usually been nudged by the Fed, which tightens monetary policy in response to inflationary pressures.  But, the unwind doesn’t have to occur in that way–it can occur without any Fed action, or even amid aggressive Fed support.

The fundamental outlooks of investors influence their assessment of the fundamental value that is present in markets, and also dictate their expectations of what will happen in markets going forward.  These impacts, in turn, influence what investors choose to do in markets–whether they choose to buy or sell.  Buying and selling determine prices.  So we have the basic answer to our question.  Market prices trend because the fundamentals they track trend, or more precisely, because the fundamental outlooks that guide the buying and selling behaviors of their participants trend.

Time Delay: A Source of Opportunity

But there’s more to the story.  Over time, trends in the fundamental outlook, and in prices, condition market participants into certain mindsets and behaviors.  When these trends change, the prior mindsets and behaviors get unlearned, replaced by new mindsets and behaviors that are more congruent with the new fundamental outlooks that are emerging.

Crucially, this process of conditioning–which involves both the Operant and Pavlovian variety–is not instantaneous.  It takes time to occur, time for repeated observed associations, repeated instances of “behavior followed by result”, to take place.  The delay can represent a window of opportunity for those investors that can identify and act quickly on it.

Academic studies have noted that market responses to earnings surprises and other unexpected news events often lag, i.e., play out over extended periods of time.  That’s not a result that any rational economic theory would predict–responses to the instantaneous release of information should be instantaneous.  Responses are not instantaneous because the participants that execute them are conditioned creatures.  To gain the confidence to buy up to the right price, if there is such a thing, they need reinforcement–the experience of seeing the price rise, when they expected that it might, the experience of having its rise force them out of a prior way of thinking about the security, and into a new way of thinking, one that is more appropriate to the new information.

Case Study:  2012 vs. 2008

Let me illustrate these points with a concrete example.  The following tables show the fundamental pictures of the U.S. stock market and economy in the 1st half of 2008 and the 1st half of 2012.  The first is quantitative, the second qualitative:

Quantitative 1H 2008 vs. 1H 2012:


Qualitative 1H 2008 vs. 1H 2012:


Take a moment to peruse the tables.  Quantitatively, in the 1st half of 2008, we had an S&P priced in the 1300s.  GAAP EPS was falling.  Operating EPS was falling.  Job growth was negative–month after month after month.  Retail sales growth was negative.  Industrial production growth was falling, and had recently turned negative.  Home prices were falling by double digit percentages.  Housing starts were plunging.  Financial stress was rising.

The data necessary to appreciate the emerging trend was there for everyone to see.  And the media was discussing it, talking recession at every turn.  Here are 6 press articles (5 from CNN Money, 1 from Heritage Foundation) from the 1st half of 2008 analyzing the results of the monthly jobs reports: January, February, March, April, May, June.  Read a few of them, so that you can remember back to that time.

Qualitatively, in the 1st half of 2008, the expansion was long in the tooth.  Large price and investment excesses had built up in the housing sector–it had become what almost everyone at the time admitted was a “bubble.”  Those excesses were unwinding in a turbulent, poorly-controlled way–a perfect driver for recession.  A tight labor market was starting to loosen and unravel.  The economy was coming out of a period of constrictive monetary policy, evidenced by a yield curve that had fully inverted two years earlier, and that had only recently come out of inversion, in reaction to Fed easing.  The Fed’s response to the deterioration was highly complacent–the policy rate was still north of 2%, despite the lack of any sign of improvement.  In terms of the price trend, the market had fallen below its 200 day moving average, and hadn’t come back.  Worst of all, there was enormous risk in the financial system–or at least, from our perspective then, enormous uncertainty–related to the contagious effects that the cascading foreclosures and bankruptcies were going to have.

Despite this truly awful fundamental picture–a picture that is admittedly easier to describe as “awful” in hindsight, when we know the answer, but that actually was awful, objectively–investors weren’t able to get truly worried, worried enough to hit the sell button en masse and pull the market’s price down to where it was eventually headed.  If they knew anything about how cycles work, which they did, then they had every reason to abandon the mature, expensive, cracking market that they were holding onto. But they held on–evidenced by the fact that prices stayed high, north of the 1300 level reached less than two years earlier.

Fast-forward to the 1st half of 2012.  The fundamental picture could not have been more different.  Quantitatively, in the 1st half of 2012, corporate earnings were in a rising trend. Payrolls were consistently increasing, month after month.  Retail sales and industrial output were growing healthily.  Housing starts were strongly positive.  Home price growth was firming, and had just broken above zero.  Objective measurements of stress in the financial system were at record lows.

Qualitatively, corporate and residential investment were rising off of recessionary levels, after years of accumulated underinvestment.  An extremely loose labor market was just starting to get tighter.  Adjusting for QE’s distortion of the long end, the yield curve was steep, and had been steep since the end of the previous recession.  The Fed–given its own recent conditioning–was laser-focused on the risks of deflation and a new downturn, and therefore monetary policy was pinned at a generationally loose level, as low as it could go, with various permutations of QE already completed or in progress, and an endless version of QE on deck, being “discussed.”  The S&P was above its 200 day moving average, and had been above that average since the Eurozone and Debt Ceiling scare of the prior year.

The question screams at us.  Why, on earth, were these markets trading at the same price? What were investors thinking?  Why were they willing to hold the crack-infested 2008 market, at a price of 1300, a P/E north of 17 (26 by GAAP), when they could have held cash, and earned 2% to 3% with zero risk?  And why, only four years later, were they perfectly willing to hold cash at 0%, when they could have held a market at a P/E of 13 (15 by GAAP), a market with a fundamental economic backdrop that was clearly improving, in real-time, on every front?

The answer, of course, is that the participants in 2008 had not been put through the experiences that the participants in 2012 had been put through.  They had not yet been conditioned to think about markets bearishly, in terms of risk, crisis, and so on–the many things that can go terribly wrong.  They still had confidence in markets, and in the system–at least more confidence than they had in 2012.  In 2008, that confidence carried things for awhile.  In 2012, the lack of it held things back.

When people are bearish, they will come up with good reasons to be bearish.  The best reason in 2012?  Surely, the Eurozone crisis.  But, on an a priori basis, the subprime crisis, viewed from a 2008 perspective, was every bit as dangerous as the Eurozone crisis was from a 2012 perspective, especially after Draghi’s “whatever it takes” promise.  Still, the Eurozone crisis got people to sell the market down to very attractive valuations, and kept people out, despite those valuations, whereas the subprime crisis didn’t, at least not until everything came to a head with Lehman.  Why the difference?  Because the participants in 2008 were carrying different sensitivities relative to 2012, sensitivities that had been behaviorally conditioned by different recent histories.  To use the analogy of driving, market participants in 2008 were normal drivers, maybe even complacent drivers; market participants in 2012, in contrast, were drivers that had just suffered life-altering car accidents.  As happens, they were prone to systematically overestimate the risks that more accidents were to come.

Transition: Not a Rational Process

The process through which risk aversion is acquired, wears off, and is replaced by risk appetite, is not a rational process. It’s a behavioral process, a process that involves the Skinnerian phenomena of punishment, extinction and reinforcement.

  • Punishment: The investor engages in the investment behavior–say, positioning into equities–and the behavior is met with harm, pain, losses, red screens.  And then again. And then again.  Confidence breaks down.  Fear develops.  The investor becomes risk-averse.
  • Extinction: The investor engages in the investment behavior, or watches someone else engage in it–but this time, the bad consequences don’t follow.  The investor engages in it again, or again watches someone else engage in it–again, no bad consequences. Where are they?  Where is the meltdown?  With time, the conditioning starts to weaken.
  • Reinforcement: The investor engages in the investment behavior, or watches someone else engage in it, and the behavior is met with a reward–rising prices, gains, profit, green screens.  So the investor repeats the behavior, or watches someone else repeat it. Again–good consequences follow.  The investor continues, ups his exposure, puts more in, and good consequences continue to follow–at least more often than bad.  Wow, this works!  Confidence develops.  Trust develops.  Belief develops.  A bullish mindset emerges.

Because the process is behavioral and experiential, it takes time to unfold.  It’s not a transition that investors can make in an instant.  That’s why an improving picture cannot instantaneously create the prices that it fundamentally warrants.  It’s why markets can only get to those prices by trending to them, gradually, as the fundamentals win out over the inertia of prior conditioning.

This transition, this learning process, is further obstructed, further slowed, by the behavioral biases of anchoring and disposition effect.  When prices fall from where they’ve been, they look cheaper, more appetizing to us.  We envision the possibility that they might return to where they recently were, rewarding us with a nice gain.  And so we experience an increased urge to buy.  It can be hard for us to fight that urge, to be patient, to stand back, when standing back is the right course of action.  Similarly, we don’t like the idea of selling and cementing a loss, or at least the idea of selling for less today than we could have sold for yesterday–we feel like we’re short-changing ourselves.  So we experience an increased hesitation to sell.

A similar dynamic takes place in reverse, when prices increase.  They look more expensive, less appetizing, to us.  We visualize them returning to where they recently were, inflicting a loss on us.  We don’t like paying more today than we could have recently paid–it doesn’t feel like a smart, profitable move.  So we experience an increased hesitation to buy.

The behavioral biases of anchoring and disposition effect make it more difficult to buy a rising market that should be bought, and more difficult to sell a falling market that should be sold.  Combined with the effects of prior conditioning, they can prevent a market from fully reflecting its fundamental strengths. But eventually, the conditioning gets unlearned, replaced with the continued positive reinforcement of good outcomes. The increased confidence and risk appetite that those outcomes give rise to overtake the inertial behavioral forces that were holding things back.

My Experience in 2012

I got out of the market in late 2010, with the S&P in the low 1200s, and stayed out, for the vast majority of the next two years.  I wasn’t as bearish during that period as I was in 2008, but I wasn’t too far off.  I saw a market that was over 100% off the lows, not far from the previous “bubble” highs.  What upside was left?  Were we going to go right back to the prior excesses?  Right back into another bubble?

On the issues front, I saw plenty to worry about: record high profit margins, a looming fiscal tightening to revert them, a potential crisis in Europe, weakness in China, and so on. The market, at 13-15 times earnings, was not enticing to me, at least not enough to make me want to walk into those risks.  I was more than able to come up with reasons why valuations “should” have been lower, and were headed lower.  And that’s what I wanted to do–come up with reasons to stay out, because I didn’t want to have to get in.  The pool was too cold.

In the last few weeks of 2012, a number of reliable people were telling me that the fiscal cliff was probably going to get resolved.  That was not what my bearish plan had called for. At least subconsciously, I wanted a large fiscal tightening to happen, so that profit margins and earnings would fall, sending the market to a lower valuation that I could then buy back in at.

I was still able to find reasons to stay out–there are always reasons to be out or in, for those that want to find them.  But for me, the fiscal cliff was the big one.  I couldn’t argue with the clear improvement in the U.S. economy, the clear uptrend in the data, nor could I argue with with the prospect that Europe would stay together, given Draghi’s demonstration of resolve.  So with the fiscal cliff about to be off the table, I had a choice to make: do I stay out?  Or do I get back in, at a higher price than I had gotten out at two years prior?

As I wrestled with the choice, I began to more fully appreciate the effects of my own behavioral conditioning.  It dawned on me that the prior downturn had conditioned me into a bearish confidence, and that this confidence was waning with each tick higher, each failed prediction.  Not only me–but those around me.  In Skinnerian terms, what was taking place, within me, and in the market as a whole, was a gradual extinction of the conditioning of the 2007-2009 experience.

So at the end of 2012, with the S&P in the low 1400s, I got back in–not with everything, but with enough.  As the market started moving in early 2013, I started getting more confident, becoming more and more of a believer.  I remember thinking to myself, in early 2013, why not go all in–100% equities?  I was fully long in 2006 without any fear–why do I fear going fully long now?  Why does that feel irresponsible?  I knew the answer: because of all the things that had happened since then, all the lessons that I had “learned” about markets.  But the truth is that I hadn’t actually “learned” anything.  I had simply been conditioned into a certain risk-averse mindset, through preferential exposure to a generationally ugly period in the business and credit cycles.  Being conditioned into a mindset is not the same as gaining knowledge, wisdom, or understanding.  The fact was, the mindset that I was carrying was not helping me position correctly in the environment that I was currently in.  So I needed to get rid of it.

It dawned on me that the rest of the market was going through the same process–a process of extinction and reinforcement.  I saw it in my interactions with others–bulls and bears.  And so I realized, I needed to go now, get in front of the process as soon as possible, to capture all of what was there to take.  If I waited for the market’s continued positive reinforcement to condition me with the confidence to go all in–which I knew it was eventually going to do–I would have to pay a much higher price, foregoing precious upside.

I thought to myself, but what upside was left in buying the market north of 1500–at prices equal to the 2000 and 2007 tops?  Were we really going to go to 1600, 1700, 1800, 1900, 2000?  Those numbers felt dangerous.  But I realized that this line of thinking also did not represent any kind of special insight or wisdom–it was just the effect of a well-known behavioral bias: anchoring.  New highs always look and feel expensive, always look and feel risky–but still, markets find a way to bust through them.  It’s true that the valuation at those prices wasn’t going to be as attractive as it had recently been, but it wasn’t going to be any less attractive than it had been in the prior cycles that I had seen, and that I had been invested in.

So I pushed myself–why not 1600, why not 1700, why not 1800?  Get those numbers in your head, acclimatize to them, get comfortable with them, so that you can find the strength to position yourself correctly for what is obviously a market headed higher, a market buoyed by a fantastic backdrop underneath it: an improving housing market, rising employment, but with plenty of labor supply still available, no private sector excesses anywhere that might give way to a recession, historically easy monetary policy with a Fed years away from tightening, a rising earnings trend (despite the profit margin fears–which were consistently being refuted by the actual results), a cheap P/E valuation, and nowhere else to get a return but in equities, with market participants increasingly figuring that fact out, putting relentless upward pressure on prices.

By the summer of 2013, I was all in–100% equities, no bonds, no cash.  Of course, I would have been much better off if I could have come to these realizations earlier in the cycle, but I can’t complain, because I ended up very well positioned for the “second leg” of the bull market, far better than I otherwise would have been.

The Questions to Ask

Now, to be clear, Skinner’s behavioral insights, as applied to markets, should not be interpreted as some kind of investing cure-all.  You can understand behavior and still be completely wrong.  But a behavioral approach at least gives us a correct model, a model that allows us to ask the right questions.  The questions we need to ask are:

  • First — What is the trend in the fundamentals of the asset class or security in question? For equities as an asset class, we might look at the trend in earnings, interest rates, inflation, the business cycle, financial and credit conditions, employment, and so on. The trend may not be clear–but sometimes it is clear.
  • Second — How have market participants been conditioned to approach and view the asset class or security in question, given their recent experiences with it?  How is this conditioning evolving over time? Is it strengthening, based on confirmation from reality, confirmation from the fundamental trend?  Is it extinguishing, based on lack of confirmation?

If, as in 2012, the first answer is bullish, with the fundamental trend improving, going up, and the second answer bearish, with market participants stuck in an overly-cautious mindset, brought about by the recent experience of full-fledged crisis, then you have a buying opportunity.  The acquired risk-aversion will gradually die off and give way to risk-appetite, with rising prices both resulting from and fueling the process–basically, what we saw from late 2012 to now, or at least from late 2012 to late 2014, when small cracks in the fundamental picture (oil, the dollar, credit, falling earnings) began to emerge.

If, as in 2008, the first answer is bearish, with the fundamental trend deteriorating, going down, and the second answer bullish, with market participants exhibiting a complacent, inappropriately-trustful mindset, conditioned by a long prior period of market tranquility and comfort, then you have a selling opportunity.  So long as the fundamental trend continues down, the complacency and unwarranted trust will eventually turn into fear and selling–with concomitant pain for all.

Now, to the question we all want answered: where are we right now?  In my view, we’re in neither place.  With respect to the question of fundamentals, we have a domestic economy that’s doing fine, embarked on a balanced expansion that has room to run, an expansion that will continue to be supported by pent-up demand in the household sector, and by historically easy monetary policy from the Fed.  Credit conditions have tightened somewhat–but we know the reason why: the downturn in the energy sector, not a larger downturn in the business cycle (unless you think the energy downturn has already caused a larger downturn in the business cycle, or will cause one–I don’t).  Earnings growth is weak, but again, we know the reasons why–falling profits in the energy complex, and a rising dollar, temporary factors that are not indicative of any larger trend in corporate profitability.  We have a global economy that’s struggling in certain places, but it will probably manage to muddle through–which is all that a domestic investor needs it to do.  Finally, even though equity returns may not turn out to be attractive, there’s nowhere else for an investor to earn a decent return–and there isn’t going to be for a very long time. That puts upward pressure on prices.

With respect to the question of conditioning, we have a mature, expensive market that has enjoyed a prolonged, 6 year run, and that has slayed many dragons and doubters along the way.  The experience has made people confident–confident to buy dips, confident to chase yield, confident to be heavily invested in equities, even at rich prices, confident in the powers of the Fed and other central banks, confident that the U.S. corporate sector will continue to demonstrate unusual strength in profitability, confident to dismiss warnings from bears, because “they’re always wrong”, and so on.  That confidence was not learned through the reliable study of any kind of history, but through a long period of cyclical reinforcement.  It’s been unlearned many times before, and will be unlearned again.

Unfortunately, then, the combination that we’re faced with–a decent fundamental backdrop with some cracks in certain places, cracks that probably aren’t going to spread, plus signs of complacency and overconfidence, at least among the investor class that has been massaged with large gains for several years now–doesn’t create a clear opportunity either way.  That’s why, with the VIX high, I prefer selling downside volatility to being long, betting on a market that goes nowhere, and that gives nothing to anyone, bull or bear.  For all the noise, that’s exactly what the market of 2015 has been.

Conclusion: A Practical Technique

To conclude, there’s a practical technique, inspired by a reading of Skinner’s work, that we can use to help us find the strength to position correctly when prior conditioning and behavioral biases are preventing us from doing so.  That technique entails making what @gcarmell of CWS Capital calls Little Bets–bets sized down to very small, manageable levels–and letting the consequences of those bets operantly condition us.   

Suppose that the market has suffered a big correction that you correctly anticipated and positioned for. Suppose further that the correction is starting to get long in the tooth, with emerging signs of stabilizaion in the factors and forces that provoked it.  So you start to get a sense–a fear–that it’s ending, that you need to get back in.  You will probably find it difficult to act on that sense–especially if, like me, you dislike taking actions that can turn into big mistakes.  You will probably find yourself seeking out and embracing dubious, feel-good reasons that will confirm your inertia and allow you to stay put–whatever “verbal behavior” you have to engage in to avoid having to jump in:

“No, this isn’t over yet, what’s happening is just a sucker’s rally, the market is headed back down, that’s what so and so on TV is saying.  Stay out!”  

You need to stop and ask yourself: Do you really believe all this?  Is it likely to be true? Maybe it is.  If it is, then the answer is to stay the course.  But if it isn’t, if the wiser part of you realizes that it’s time to get back in, but you aren’t able to muster the willpower to actually do that, to actually take that plunge, then the solution is to go in with only a small amount–however small it needs to be in order to not be met with resistance.  See what happens, see what consequences follow.  You can rest assured that if the trade does well, you will find yourself with increased confidence and appetite to do more of it, in characteristically Skinnerian fashion.

The same holds true in the other direction–when you sense that its time to get out of the market, after a long period of market prosperity that is starting to crack.  If you can’t find the strength to make large bets against something that has been winning for so long, then don’t bet large, bet small.  Sell a few shares, see what happens.  Not only will you be giving the market an opportunity to condition you into the position that you think you should be taking, you will also be “selecting by consequence”–in our evolutionary world, that tends to be a pretty good strategy. 

In my own case, I suspect that if I had not started small, with manageable bets at the end of 2012, I would not have been able to get to what, for me, was the appropriate bull market position–fully invested.  Those bets laid the foundation for a growing confidence that ultimately led to full conversion.

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