Cognitive Dissonance in The Markets

Explanation

Cognitive dissonance is an uncomfortable feeling caused by holding conflicting ideassimultaneously. The theory of cognitive dissonance proposes that people have a motivational drive to reduce dissonance. They do this by changing their attitudes, beliefs, and actions. ^[2]Dissonance is also reduced by justifying, blaming, and denying. It is one of the most influential and extensively studied theories in social psychology. (Source:http://en.wikipedia.org/wiki/Cognitive_dissonance)

The following facts provides clear evidence of the emergence of cognitive dissonance in the markets. The question arises: Who is going to change their attitudes, beliefs and actions? Will it be the bulls, who are currently rationalizing that corporate earnings are going to continue growing strongly (as evidenced by the recent strong break up in the market)? Or will it be the bears, who are focusing on rising public debt levels and are currently rationalizing that debt levels matter?

Quote:

"Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery." (Mr. Micawber, Charles Dickens)

So, have the principles changed since the days of Charles Dickens? The market seems to think so.

US Banks Warn Obama on Soaring Debt

www.cnbc.com/id/42775820

Today's strong break up in the markets is a clear sign that the majority of investors believe the debt limit will be lifted by at least a trillion dollars and that corporate earnings are going to continue rising.

Here are some simple and easy to understand facts based on the current Public Debt level of $14.3 trillion:

1/14.3 = 6.99% (The percentage by which the market thinks the Public Debt ceiling will be raised)

Movement of public debt in preceding 10 years:

April 25th 2001: $5.68 trillion

April 25th 2011: $14.3 trillion

Compound rate of growth: 9.67% p.a.

Movement of Dow Jones (round numbers):

2001: 9,000 (low)

2011: 12,000 (April)

Compound Growth rate: 2.9% p.a.

Interim conclusions

• If compound growth in borrowing of 9.67% p.a. has yielded equity price growth of 2.9% p.a. then raising the debt ceiling by 6.99% (by itself) is not going to push equities to new highs
• Clearly, the market believes one of two things:
  • The debt ceiling will be raised by far more than 6.99% during 2011/12; or
  • Underlying earnings are going to rise strongly because corporate earnings are going to rise strongly

Now let's look at the movement of public debt since 2008 (when the Global Financial Crisis emerged):

April 25th 2008: $9.3 trillion
April 24th 2009: $11.1 trillion (+19.3% - as a consequence of GFC in September)
April 26th 2010: $12.9 trillion (+16.2%)
April 25th 2011: $14.3 trillion (+10.9%)

Compound Growth rate: 15.4% p.a.

Dow in October 2008: 8000
Dow in 2011 (April): 12,000

Compound growth rate: 14.5% p.a.

Alternatively:

Dow at low (in 2009): 7,000

2011 (April): 12,000

Compound growth rate: 30.9% p.a.

Interim Conclusion

Investors are focusing on the lower number of 7,000 as opposed to the earlier date at which stimulation began to kick in. (The markets began to collapse in September 2008)

Conclusions

• The facts are clear that government borrowings have risen at a faster pace than equity prices
• Therefore, for equity prices to continue rising, either:
  • US Public Debt will have to explode at a rate that is far greater than the historical 9.67% p.a., or
  • Underlying corporate earnings are going to have to continue rising because of a strong economy

Question: What is going to "drive" the growth in underlying earnings, given that world energy output per capita is not growing?

Overall Conclusion

The market appears to believe that public debt is going to continue to explode as the Fed continues to stimulate with further Quantitative Easings

Quote from the above article:

"The world is watching, and while America must pay its bills, if we ask for more credit, we must prove worthy of it," a spokeswoman for Eric Cantor, the House majority leader, told the Financial Times.

"That's why President Obama, vice-president Biden and the leaders of their party are obligated to ensure that any debt limit increase is accompanied by serious reforms that immediately reduce federal spending and reverse the culture of debt hovering over Washington."

Analyst Observation

The probability of a train smash is rising!

Brian Bloom

Author, Beyond Neanderthal and The Last Finesse

www.beyondneanderthal.com