Pavlovian conditioning is a learning process that involves pairing a stimulus with a conditioned response. In the famous experiments that Ivan Pavlov conducted with his dogs, Pavlov found that objects or events could trigger a conditioned response.
What is most interesting is that the market action off the March 2009 lows has been conditioning investors with the same Pavlovian process. Investors have been taught that market dips are always bought, and the market always comes back higher and stronger. In fact, the deeper and faster the pullback, the faster the next rally has taken shape, with many of the pullbacks lasting only a short time, and retracing only a small percentage of the prior rally.
As we have even seen quiet recently, the market action during every decline and ensuing V-shaped rally has been re-enforcing the perspective that the market always comes back faster and stronger than before. Many investors have now come to believe what this commenter to an article I was reading noted: “any correction from here on out will be quick and v shaped.”
And, with the S&P500 rallying 1600 points off the March lows despite the worst of the Covid news and economic lockdowns seen throughout the country during the heart of that rally, investors have now been trained to simply “buy the dip,” as nothing else seems to make sense to them.
While the general underlying assumption causing these V-shaped rallies is due to the Fed backing the market or the government stimulus, my perspective is that this is a very superficial way at looking at the market. But, however you view the market, there is no doubt that the action we have seen over these past `12 years has now conditioned investors to assume that every major dip is certainly going to be bought, as the Fed and the government are standing behind the market, always willing to pull whatever trigger is necessary in order to prop the market back up again. The market has trained us in a Pavlovian manner to such an extent that we have indeed created a moral hazard.
As an example, I was reading an article this morning, and I saw a comment representing what I believe to be a commonly held belief about the market currently: “Investing Rule #1: if you want to make money in the market, stay in the market. Through corrections, bear markets, recessions and even depressions, long term, stock markets have always gone up.”
However, as we continue higher and higher, and investors become more and more certain that “stock markets always go up,” and will always come back no matter how drastic a decline we see, do you really think this is going to continue forever?
Not only has the market culture now been trained in a Pavlovian manner, it has matured to the point where the potential for a protracted bear market has grown to levels not seen since the Great Depression. Our national debt continues to grow exponentially to levels at which it has become clear that the US will be unable to pay back the underlying debt. The current administration is poised to add its significant share to further inflate our national debt to levels inconceivable only decades ago.
Moreover, we are nearing a point in time where interest rates will undoubtedly begin to rise as we look towards the 2023 time-frame and beyond, which will then present us with a scenario that the US may not even be able to afford the interest payments on its spiraling debt debacle.
Now, if you think linearly, then I am sure you are now believing that interest rates can always be kept low, as the Fed has matters well under control. But, those who forget the lessons of history are bound to repeat them. And, it seems many have forgotten the lessons of the Great Depression, which clearly showed us that the Fed does not have the control that so many have been led to believe in recent times.
“The Federal Reserve System, from February to December 1931, increased the issue of Federal Reserve notes by 80%. These issues were due to bank failures which made necessary a larger use of cash. Yet, after a wave of bank failures . . . both banks and their depositors began raiding each other in a cut-throat competition which more than defeated the new issues of Federal Reserve notes.” Irving Fisher, Booms and Depressions, 1932
Oh, yes, I know all the counter arguments. This is a different time and the Fed is so much smarter now. But, is it really? Or has a bull market masked the true ineffectiveness of the Fed at times of true crisis. Even most recently, the Fed made several attempts at preventing the last 35% market crash, and utterly failed.
While you may don wonderfully effective blinders and say that the Fed “eventually” caused the market to bottom, I would suggest you look closely at that chart again after reading the words of former Fed Chairman, Alan Greenspan:
“It's only when the markets are perceived to have exhausted themselves on the downside that they turn.”
If you are being honest with yourself, then you will come to the realization that Mr. Greenspan is correct, and most market pundits and analysts really do not understand the way the markets work. At the end of the day, the market is much stronger than the Fed.
Allow me to present some evidence which should hopefully open your eyes to the true lack of control of our Federal Reserve.
Back in July 2011, during the heart of all the Quantitative Easing machinations, market participants were thoroughly convinced that the Fed’s actions were going to destroy the US dollar. Yet, in July of 2011, when the US Dollar was down in the 73 region, we called for a multi-year rally with a target of 103.31. While many thought our expectation to be utterly preposterous in light of all the QE abound, the Dollar began a multi-year rally from that month, and topped five and a half years later at 103.83. (Yes, I know I was off by 52 cents).
Based upon these facts, one has to at least question how effective the Fed was at keeping the dollar down, which was an expectation held almost unanimously at the time.
Let’s take another example. Back in late 2018, as the Fed was well into its rate raising trend, we again fought the Fed, and called for a major rally to begin in TLT in November of 2018. And, again, I heard the same chatter that “you can’t fight the Fed,” blah blah blah. Well, if you look at the TLT chart, you will notice that this was the last major low struck in the TLT, as we began to rally from the 112 region towards the 180 region. And, in true Fed fashion, it had to follow the market and eventually begin to lower rates, as that is what the market demanded.
Again, in light of the actual facts, one has to truly question the pervasive view that we “cannot fight the Fed,” and wonder if the Fed has any control over the market, or if they simply follow the market. I am quite confident in my personal conclusion, which is based upon the facts of history and not some commonly held belief in supposition or fallacy.
Maybe this chart published by Elliott Wave International will highlight this perspective for you as well:
And, this one shows the same for 2018 and 2019 as well:
Yet, we foolishly believe that there are powers that can spare us from the pain that is inevitably inflicted upon investors within our financial markets.
“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, again and again, to lower the gross market rate of interest by means of credit expansion. There is NO means of avoiding the final collapse of a boom brought about by such credit expansion.” Ludwig Von Mises, Human Action, 1949
Consider that we are approaching the 100-year anniversary of the Great Depression. And, as such, we are again entering a period of the “roaring twenties,” especially if the market is going to attain the projection I expect over the coming two years. Does anyone else see the potential for history to again repeat itself? Yet, this time, the moral hazard is significantly elevated.
Allow me to present to you what our financial leaders back in the 1920’s said about our markets. For those that know their stock market history, you would know that those “in the know” were absolutely certain about the impossibility of a market crash right before the market crashed and led us into the Great Depression. Let me show you a few examples:
"We will not have any more crashes in our time."
This was said John Maynard Keynes in 1927, two years before the stock market crash which lead to the Great Depression.
"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as they have predicted. I expect to see the stock market a good deal higher within a few months."
This was said on October 17, 1929, a few weeks before the Great Crash, by Dr. Irving Fisher, Professor of Economics at Yale University. Dr. Fisher was one of the leading US economists of his time.
"I cannot help but raise a dissenting voice to statements that we are living in a fool's paradise, and that prosperity in this country must necessarily diminish and recede in the near future."
- E. H. H. Simmons, President, New York Stock Exchange, January 12, 1928
"There will be no interruption of our permanent prosperity."
- Myron E. Forbes, President, Pierce Arrow Motor Car Co., January 12, 1928
And, these are just a few of the popular quotes of their day. And, by the way, has anyone heard of the Pierce Arrow Motor Car Company? You have not? Well, that is because they went bankrupt during the Great Depression. But, I digress.
Now, let’s bring this back to our current times, 90 years later, where our former Fed Chairman and current Secretary of the Treasury pronounced back in 2017 that the banking system is "very much stronger" due to Fed supervision and higher capital levels. But, she then followed that up with what I believe will be a history-making statement, akin to those quoted above from generations past. Yellen also predicted that because of the measures the Fed has taken, another financial crisis is unlikely "in our lifetime."
My friends, enjoy the good times and the current “roaring twenties” as we have them now in the stock market. We are currently setting up for a major market rally for 2021, likely lasting into 2022 and potentially into 2023. However, once this rally runs its course, I believe we are setting up what may eventually be entitled the “Greater Depression.” In fact, my minimum expectation once this rally completes over the coming years is a return to the 1800/2000 region. And, that would be the good news. There is great potential we can drop as deep as the 1000/1200 region from much greater heights than we reside today, which would be within an unprecedented and protracted bear market lasting potentially well into the 2030’s.
Moreover, we are seeing a tremendous public backlash against hedge funds as we enter this final phase of the bull market. The current situation surrounding Gamestop and Robinhood has highlighted the public loathing and animosity towards hedge funds. In fact, the trend over the last decade has been a declining one for the hedge fund industry as a whole.
But, while many of you may think hedges funds, or short trading in general, to be evil, please remember that short traders provide liquidity to the markets, which allows markets to run more smoothly. Should you take out the hedge funds and/or the short traders from the market, you create a vacuum below market price which is what exacerbates a market decline.
So, consider that as we head higher in the coming years, and there is further backlash against shorting the market. As more and more hedge funds and short traders may be forced out of the market, not only have we created a moral hazard, as I have outlined above, we are setting up what potentially may be the biggest crash ever seen in market history. Indeed, we are heading into the “perfect storm.”
I know you all read many financial articles, with most authored by either being perma-bears or perma-bulls. While this article may seem to present me as a perma-bear, I can assure you I am neither perma-bear nor perma-bull. Rather, I am simply a realist who is focused on perma-profit. To this end, I recognize the coming 2 years as an opportunity to appropriately prepare for what may be one of the worst financial crises seen over the last 100 years. While we may be partying over the next few years, please keep in mind that parties always come to end, and we will eventually have to pay the piper. It is truly inevitable.
Again, while I still believe there are several years ahead of us to profit in the stock market and am quite bullish at this time, I wanted to at least balance that with a presentation of market context as to where we reside within the multi-decade trend. So, as we progress towards what I see as a potentially generational market topping event, I will begin to pen further expectations and analysis for our members to prepare for this event in the coming years. So, stay tuned, for as Ben Franklin famously noted, “by failing to prepare, you are preparing to fail.”