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Why Another Upside Move Can't Be Ruled Out

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The role of portfolio managers as market movers can't be ruled out.

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Editor's Note: The following was posted in real time on our premium Buzz & Banter (click for a free trial). It's being shared here for the benefit of the Minyanville community.


Following up on yesterday's insightful comments made by Professor Janice Dorn in Trading Lessons: Learn to Leverage Your Risk Aversion I would add the following remarks:

1. My own thinking on economics and financial markets has been significantly influenced by behavioral psychology in general and the applications to economics performed by Kahneman and Tversky and others. I highly recommend that investors become familiar with this very important and dynamic line of research. It is probably true that there has perhaps been a bit of a "bubble" of "behavioral finance," in which some of the insights of behavioral psychology have been mis-applied or over-applied. Still, it is a very fruitful area of research well worth while getting familiar with.

2. The issue of "framing" that Professor Dorn brought up is very important. In that regard, I would point folks to my article, Memo to Portfolio Managers: Want to Keep Your Job? Buy Stocks. In that article, you will see that I believe that for portfolio managers, the issue is framed something like this:

Which of the following do you prefer?

1. The certainty of keeping a very high paying job simply by being fully invested and mimicking your benchmark.

2. Taking a chance of being underweight equities. In this event, you have 2 potential outcomes: If you're right, you might get a performance bonus worth about 10% of your salary at best (not much more, because being underweight equities in a bear market isn't nearly as profitable for the firm as being overweight equities in a bull market). But if you're wrong, you have about a 35% probability of being fired and losing 100% of your salary.

I don't know about the good doctor, but I would predict that, particularly in the current environment, in which it's very difficult to find jobs, the overwhelming tendency is for portfolio managers to choose (2).

This is why, despite my increasing fundamental concerns, I believe that a further explosive upside cannot be ruled out. Furthermore, in assessing a potential downside scenario, we must take the following psychological factor into account: Managers that have been underweight during the recent upside spike will feel "relieved" as the market declines, and chastened by the upside scare, will tend to "buy the dips," so as to not place themselves in that scary position again. This factor will tend to mitigate the intensity of any downturn.

You can also check out my article of yesterday -- Three Reasons to Short Gold Now -- for my take on GLD, GDX, DZZ, and the US dollar.
No positions in stocks mentioned.
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