Underestimating the Reflex

You've gone too far this time
But I'm dancing on the valentine
I tell you somebody's fooling around
With my chances on the dangerline
--Duran Duran

Back in late 2008 I began anticipating a big rally to balance out the waterfall decline in progress. Nothing prescient about that, really. After all, we know that markets don't travel in straight lines.

That rally began in March of 2009. And it has been powerful. 'Has been' is operative because the rally is still in motion--something that I did not anticipate.

What have been the key factors that I have not anticipated? One has been the conviction of the Fed and other central banks to manufacture inflation at all costs. I 'knew' that Bernanke had it in him but thought that he would flinch when it came to enacting extreme measures likely to destroy future prosperity. Seemingly, I have overestimated his intelligence and underestimated his political will.

The other thing I did not foresee is people's tendency to once again forget the past and jump back into the game with leveraged risk. In the past few months especially, I've observed risk taking reminiscent of 2007 before things fell apart.

I probably should have anticipated such. After all, prospect theory (Kahneman & Tversky 1979) tells us that people are likely to take more risk when they are behind. And when people are way behind, the reflexive behavior promises to be potent.

Mix cheap money with reflex for recovering losses, and you get a greed cocktail that works until the bar closes.

position in S&P

References

Kahneman, D. & Tversky, A. 1979. Prospect theory: An analysis of decision under risk. Econometrica, 47: 263-292.