Two percent inflation, that is.
By Michael Bailey
The hit song “We Don’t Talk About Bruno” from Lin-Manuel Miranda and Disney involves a family that tries to ignore a central character, Bruno, who has “psychic powers [and] has ruined lives with his negative prophecies (1)”. Markets in 2022 appear to be doing the opposite, embracing dire forecasts of runaway inflation, followed by Federal Reserve tightening and pressure on stocks. Markets are not talking about two percent inflation, no. Instead, investors appear to be ignoring the possibility that lower inflation could benefit risk assets.
Why are investors making a leap from high inflation to selling risk assets? Behavioral finance themes, such as judgment and noise, an inside view, and an availability cascade may be at play here. Bias and emotion could be creeping into valuations as investors jump on a bandwagon of high inflation, high interest rates, and high pressure on risk assets, such as tech stocks.
But what could happen to risk assets if we go back to the old normal of slow and low growth? Perhaps a broader view that tries to cut through bias and emotion may reach a different conclusion about inflation and risk assets. This article explores three behavioral finance concepts that may be weighing on markets.
Judgment and Noise
Why are investors so confident that inflation is careening out of control? Buyers and sellers are “trying to draw concrete conclusions from a chaotic ocean of events, data, and opinions (2).” One day, Jay Powell and the Federal Reserve tell us that inflation is transitory, and then they pull an about-face and tell us that inflation is scary and red-hot. Will car prices come down when the global semiconductor shortage unwinds? Or will a tight job market fuel a multi-year vicious cycle of cost-push inflation?
Nobel laureate and behavioral economist Daniel Kahneman believes that messy data, or noise, can distort our judgment (3). The bottom line here is that “anytime humans are making a judgment, noise likely clouds the person’s ability to make the best judgment or decision (4).” As investors look at buying individual stocks in this situation, “the combination of noise and judgment can be particularly worrisome when trying to pull diverse sets of data together to craft an investment thesis for a company (5).”
How can we make investment decisions when surrounded by noise? As discussed in Stop. Think. Invest, “If the level of noise seems excessive, you may need to lower your level of confidence in the portion of the thesis that the noise is impacting (6).” Perhaps baby steps, rather than huge swings, may be the better option when noise distorts our judgment.
What You See Is All There Is (WYSIATI)
Sticking with Daniel Kahneman, let’s take a look at a bias many of us have as we try to make decisions. Do we absorb all available information, or just take a quick glance at what happens to be right in front of us? “Generally, investors can get in trouble focusing on existing evidence and ignoring absent evidence. Kahneman refers to this bias as What You See Is All There Is, or the tongue-twister WYSIATI for short (7).”
Kahneman talks about a dangerous situation where people use a lazy form of thinking (called System 1 thinking) to “try to make sense of the world with whatever information happens to be in front of us, rather than digging for all of the relevant data. With limited information (WYSIATI), System 1 thinking can put us on autopilot as we jump to conclusions (8).”
In early 2022, investors may be getting sticker shock at the gas pump and in the supermarket, leading potentially to lazy System 1 thinking that anticipates a massive Fed response and pressure on equities. Perhaps a broader view of existing inflation data and Fed action scenarios may allow for upside possibilities for markets.
Availability cascade
A third theme that may be impacting markets this year is “a feedback loop where the media may overreact to a relatively minor problem, triggering a stock selloff, which attracts more media attention, and so on. Kahneman describes this vicious cycle as an availability cascade where decision-makers judge the importance of an idea by how quickly and emotionally the idea enters our thinking (9).”
We could be seeing an availability cascade this year, especially if investors are selling everything, rather than sifting out the good from the bad. “This may be especially true if your stock has improving fundamentals, but other stocks in the industry are suffering slower growth, market-share loss, or lower profitability. An availability cascade can temporarily obscure winners and losers in an industry (10).”
How can we push back against a possible availability cascade? I coined a term called System 2 due diligence (11) in Stop. Think. Invest., which basically means roll up your sleeves, do some primary research, and let your spreadsheet be your friend as you analyze upside and downside scenarios for your stock.
Conclusion
Investors might be sticking their heads in the sand and ignoring the possibility that gloom and doom scenarios with high inflation might be excessive. Will markets keep chanting, “We don’t talk about two (percent inflation), no”? Perhaps taking a deep breath and becoming aware of bias and emotions can help investors avoid Bruno’s negative prophecies.
Notes
1. A recent Wall Street Journal article notes that the song hit number four on the Billboard Hot 100.
2. Stop. Think. Invest, page 69.
3. Kahneman goes deep into this concept in his book “Noise: A Flaw in Human Judgment”. May 18, 2021. Daniel Kahneman, Olivier Sibony, Cass R. Sunstein.
4. Stop. Think. Invest, page 69.
5. Ibid.
6. Ibid, p. 71.
7. Ibid, p. 32.
8. Ibid.
9. Ibid, p. 115.
10. Ibid.
11. Ibid, p. 45. Kahneman describes System 2 thinking as reflective, analytical, and rigorous, almost the complete opposite of the automatic, go-with-your-gut System 1 thinking.
