Sunday, October 15, 2017

Sentiment is counter-cyclical. Policy views are pro-cyclical

I thought this was an interesting and telling chart.  And it is a nice piece of evidence against the various macroeconomic theories that are built on the idea that pro-cyclical investor sentiment drives business cycles.

This sure looks like counter-cyclical sentiment to me.

This is related to another great chart that I recently came across.  Sentiment had turned south in the housing market well before 2004.

This counter-cyclical sentiment is, I believe, the reason why we have macroeconomic theories that project a pro-cyclical sentiment.  If sentiment in some group is counter-cyclical, then that group will be convinced that their aggregate sentiment is pro-cyclical.  This is why I am only slightly flippant when I suggest that a reasonable monetary policy rule would be to conduct surveys about what policy shift is most favorable, and then do the opposite.

Think about it.  The reason that it seems like housing markets were out of line in 2005 is because practically everyone knew that prices were too high, yet prices kept rising.  When prices kept rising, lo and behold, there were buyers and sellers who were thumbing their noses at our communal sentiment.  There were even some buyers who were pretty excited about it.

Now, there were certainly some types of buyers and some types of speculators who were more active in the market than usual, at the time.  But, our perception of those buyers is skewed by our counter-cyclical perceptions.  Consider that the housing stock is pretty stable.  We don't suddenly double the number of units in a bull market.  And, think about all the anecdotes from 2005.  Small time speculators who owned a half dozen homes in the sand states.  Janitors in California talked into buying a home with a mortgage that would claim 90% of their take-home pay.  Etc.  Add up all the buyers in your mind.  Think about the fact that for that small time speculator, there had to have been a half dozen former homeowners who sold their homes to the speculator.  There are only so many homes to be owned at any time, with only marginal changes, so those homes had to be bought from someone.

How many articles were in periodicals at the time about all the former homeowners who exited the market?  How many books line the shelves at your local library about how many former homeowners sold out in 2005 or 2006?  For every naïve speculator with a half dozen leveraged homes there must have been several.

Our point of view controls these perceptions as much as facts do, and our point of view is counter-cyclical.  We really notice when market activity betrays our point of view.

We can see this in the stock market in the image above.  As prices rise, sentiment sours.  Yet, the price keeps rising.  How can that be?  It's because price is surprisingly immune to sentiment.  Markets take in a huge amount of primary, secondary, and tertiary investor activity and input.  Market participants may not bid up stock prices because they are in a speculative mood.  Maybe, they bid up prices because prices are cheap, in spite of sentiment, and that fact is manifest in prices, even though our primary market sentiment is weak.

How do we reconcile the chart above with the growing number of anecdotes like this one?


Uber driver in OC says she and husband were in real estate, lost all in 2008. Only now venturing back into "investment real estate." Hmm.
— Bethany McLean (@bethanymac12) October 14, 2017


Do the 4% of potential investors who are feeling bullish and speculative all happen to be Uber drivers and such, or does our counter-cyclical sentiment cause these anecdotes to become more palpable when we are bearish?

We interpret our perceptions as a confirmation of pro-cyclical sentiment.  But, in reality, prices are not particularly sensitive to sentiment.  Intrinsic value of assets is more stable than our sentiment is, but we treat our perception as fixed and we dismiss the efficiency of markets.  So, as our sentiment swings above and below the market, as it generally follows intrinsic value with some small amount of deviation, we come to a conclusion about prices that is the opposite of reality.

And, what is the result?  Where we have the ability and resolve to impose our "theory by attribution error" * on markets, we impose cyclical instability.  When sentiment is bearish, we become convinced that stubbornly bullish sentiment is pushing prices too high, and we demand policies that will dampen economic activity.  When sentiment is bearish, policy becomes bearish, and our sentiments are confirmed.


This survey data appears to contradict the data in the above tweet, and suggests that investors expect gains, even though they don't personally think the market is undervalued.  This could be due to speculative fervor, or it could be a realistic expectation of rising real production that causes values to increase along with economic growth.  Even in this survey, the average respondent's expectation is for something just under 5% for the quarter, with a negative skew.  That doesn't seem particularly unreasonable.  But, the negative skew of expectations has definitely declined over the past year.

* "We" base our personal point of view on an assessment of market conditions, the business cycle, and hard earned wisdom.  "Others" are creatures of fear and greed, chasing after every trend.


  1. Thought-provoking post.

    Personally, I wonder about the "expectations" school of macroeconomics. Maybe US house prices would have never retreated, unless the Fed hammered them down by raising rates into a soft economy. Other nations have seen house prices rises, plateaus, and more rises. Of late, some markets softened on China capital controls.

    I often read it is key that the Fed tell the market what to expect. I wonder if anyone in the market is listening to the Fed. You sell for what the market will bear today, in housing, labor, goods, services.

    In fact, in competitive markets, if someone has foresight and adjust prices before the fact (they read the Fed is easing or tightening) they will lose income or sales.

    1. Foresight wouldn't necessarily lead you to change menu prices. It would lead to changing production plans, selling or buying assets, etc.