Imagine you are a cow. You and all of your cow friends are not particularly in danger, but you know that danger is never too far away. One of your most respected cow brethren prophesizes that “storm clouds” are ahead and that conservative strategies will yield the best results. Another cow, who is perpetually shaking in fear, feels the looming sense of danger even more strongly now. All of the sudden, a tree branch falls from a nearby tree and just one cow decides that the danger is too close. First, it is just a handful of cows running, then, without a proper sense of where the threat is coming from or how dangerous the situation is, more cows join in. Soon, even the most stable and confident cows are all running in one direction away from a tree branch. Stampedes are frightening and can be dangerous, but you, as a cow, know that running with the herd is the safest course of action as to not be trampled.
These sorts of positive feedback loops exist in the herd mentality of cows, and also the herd mentalities of humans alike. Notice how with each successive cow joining the stampede, it is more likely that the next cow joins the charge. Cows, like people, exist on a spectrum of confident and calm, to skittish and anxious, and each event in the series will trigger a different risk profile of cow. Some cows will start running at the snap of a twig, and some cows will only start running when running seems necessary for self-preservation. These animalistic instincts are certainly not lost on humans and we see them in action every single day in our economic markets.
Reflexivity is the theory that the market fundamentals do not always influence price, but instead, it is price that is able to change the underlying fundamentals. In the same way that a stampede starts, once a small noise is found to be moving an asset price, other investors will jump on board throwing the price out of equilibrium. The sentiment of the market continues to move the price up as investors then accept that the growth of the price is a given and should be baked into the value of the asset. Note that this pattern is a self-fulfilling prophecy. The price goes up because some respected investor prophesied it, and the mechanics of the market proved him right. Eventually, the sentiment is reversed for one reason or another and the price drops catastrophically. Just as this sentiment in society moved the asset price far higher than its equilibrium, the correction will move the price lower than its equilibrium. The mechanics underlying this phenomenon are not scientific or logical, they are based on feelings and emotions.
For a more concrete example of this, let’s look at the US debt market which is often seen as a benchmark for the rest of the economy. Buying debt from the US government is a tried and true method for the return of capital as we have discussed previously in our newsletters. The debt instruments that guarantee this return are bought through auctions meaning that price discovery is an ongoing process. When investor sentiment is generally negative, we find a reflexive positive feedback loop and the price will drop precipitously as yield rises. The reverse is also true where an overly optimistic public sentiment about the economy will drive the price of each bond up and yields will plummet. Keep in mind that, just like the stampede, there are very few forces that can stop this dramatic rise and fall.
Today we find that investor sentiment has fouled up as a result of the pandemic, the government response to it, the Fed’s response to the government response, as well as a whole host of other geopolitical reasons. Regardless of the reasoning, the 10-year treasury is on the rise, fueled by a positive feedback loop of doomerist expectations. This 10-year treasury is then affecting other investment markets as even steadfast investors begin to run with the rest of the herd. In real estate, we have had plenty of investors cite the 10-year treasury rate as a reason to pull back investment, and who could blame them?
Unfortunately though, the expectations and feelings of investors have effects on the real world and are not just bottled up into the yield rate of debt. Public sentiment is a powerful force that can bankrupt businesses, create and destroy wealth, and topple governments. This fact is certainly not lost on Jerome Powell who, when discussing inflation and the Fed’s intention to change public sentiment, said, “If the public expects that inflation will remain low and stable over time, then, absent major shocks, it likely will. Unfortunately the same is true of expectations of high and volatile inflation.” He goes on to quote former Chairman Volcker saying, “..part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.” Chairman Powell is stating publicly and explicitly that the expectations of the public are entrenched in a positive feedback loop and it takes an external force to break the loop and stabilize the economy.
One of the most visible, and fascinating, examples of public sentiment would be a bank run. Bank runs are a quirk of our financial institutions and are only possible thanks to a series of innovations beginning with the Swedes in the 1600s. For those of you who do not know, bank runs are possible thanks to the fractional reserve system. This means that banks only need to keep a fraction of the money that you store with them on hand at any time. The idea is that, as long as every customer does not come to the bank looking for their money all at once, the bank will be able to loan out some of the money at a profit while also being a service for customers to store their weath. When public sentiment changes, and people flock to the banks hoping to get all of their money out, the fractional banking system completely falls apart, and the bank defaults. In order for any bank run to happen, the bank must lose trust in the eyes of its clients, but this does not always have to be the fault of the bank itself. In fact, the first bank run in history was, arguably, not the fault of the bank at all.
The first central banker in history was named Johan Palmstruch and he was appointed by the king himself to modernize Swedish banking. At the time, Swedes used very large copper plates called dalers as currency with the largest of these plates weighing 20 kilos. Imagine carrying coins weighing 44 pounds in order to make transactions… Palmstruch’s idea was to hold onto people’s dalers and give them receipts. These receipts were then circulated around the economy as bills would be today. Unfortunately for Palmstruch, King Charles X Gustav died and the new king had a very different idea of currency stability. King Charles XI decided to replace the old dalers with new copper plates that were worth less than the dalers that Palmstruch was holding onto. Swedes began trying to cash out their receipts for those old dalers because their value had suddenly shot up and Palmstruch could not comply except by printing more receipts. Of course, when the public realized that these receipts could not be cashed out for dalers, the bank collapsed and the first central banker in history was stripped of title and imprisoned.
Every successive bank run in history would follow the same pattern set by Johan Palmstruch. The bank engages in fractional reserve and makes money through lending, some change happens to the underlying currency or asset, and then a lack of trust in the bank drives clients to pull out their money. This was true during the Great Depression, and it is true of the bank runs happening right now in China. Public sentiment is what carries financial institutions through good times, and it is what destroys them in bad times. If you wish to predict the future, you must begin with the emotions of investors.