Wednesday, February 20, 2013

Positive Feedback Loops and the Stock Market

Writing in his book The Signal and the Noise:  Why So Many Predictions Fail - But Some Succeed, Nate Silver discussed the roles that "negative feedback" and "positive feedback" play in our daily economic lives.

Negative feedback is a concept that all of us learned early on in our economic studies, since it really is nothing more than Supply and Demand.

The higher the prices go, the lower sales go. Most of our economy runs on the concept of negative feedback.

In his book, Silver quotes economist and former director of the National Economic Council Larry Summers as saying that this negative feedback loop acts as kind of a thermostat in our economy, preventing it from going into recession or becoming overheated.

Positive feedback, on the other hand, stands supply and demand on its head.  The higher prices go, the more demand rises.  Examples might be college tuition, or alcoholic drinks such as fine wine or aged scotch.

And, oh yes, stocks.

Unlike negative feedback loops, where price changes play an important role is moderating behavior, positive feedback loops can also be described as fear and greed.

It has been well-documented that the higher stock prices rise, the more investors decide to add to positions. We've seen this phenomena several times over the last 20 years. Investors couldn't get enough of stock mutual funds in the late 1990's, despite historically lofty valuations and numerous warnings from seasoned investors that the enthusiasm for stocks was overdone.

The more stock prices rose, the more greed investor behavior became.

More recently, since the credit crunch of 2008 and subsequent market swoon, investors have shunned the stock market in favor of bonds, despite record low levels of interest rates.

In 2009, when stock valuations were at multi-decade lows, enthusiasm for stocks was scarce, as fear of the future dominated investor thoughts.

In recent weeks, much has been written about "The Great Rotation" from bonds to stocks that appeared to have begun last month.

Problem is, it is not necessarily clear from the data that this rotation is actually occurring.

Here's an excerpt from the "Buttonwood" blog on the Economist magazine website:

Plenty of banks and brokers pay great attention to cross-border money flows rather like Roman augurs sorting through chicken entrails for indications of the future. But a note from Jeffrey Rosenberg at BlackRock points out that the causation goes the other way
We ran a Granger causality test on 5 years of monthly stock and bond data. The data clearly indicate that past returns help to predict future flows; past flows show no similar predicted power on future returns
In other words, flows follow returns, not the other way round. People hear that the stockmarket is doing well, think "I'd like a piece of that" and pile in. it is part of the odd nature of asset markets that a rise in price causes an increse in demand, not a fall. Conversely, a very sharp fall in an asset price can put investors off for a considerable period.  As Mr Rosenberg points out, since 2008 equity mutual funds have seen a net $460 billion of outflows since 2008; that hasn't stopped the stockmarket from rallying strongly from its spring 2009 low.

Indeed, he adds that there was no great rotation from bonds into equities in Janaury; both sectors recorded net inflows ($13 billion for the former and $45 billion for the latter). There was a rotation out of cash; money market funds saw net outflows of $21 billion and commercial bank deposits by $141 billion.

The question of whether the market continues its current upward trend, then, could oddly be determined by whether stocks continue to rise, and not necessarily on analyzing money flows.