Most of you are probably familiar with Aesop’s famous fable “The Fox and the Grapes.” But if you’re like me it was some years ago when you last heard it, and you might have forgotten. Here’s a less-than-eloquent summary.
The story goes that a fox was walking through an orchard and saw a bunch of grapes hanging from a vine quite a distance from the ground. The fox decided to take a running jump in an effort to pluck the bunch out of midair.
After considerable effort and several jumps he gave up, concluding that the grapes must be sour anyway. The moral of the story: It’s easy to despise what you can’ get.
This fable is often cited as an example of cognitive dissonance, a psychological discomfort that happens when a person’s pre-existing beliefs, desires or theories conflict with new information or facts. In other words, it’s a situation where a person is presented with two compelling ideas that aren’t consistent. The typical reaction to reduce the mental conflict is to rationalize your position in an effort to eliminate the inconsistency.
The fox obviously likes grapes. Otherwise he wouldn’t have spent so much time trying to grab them from the vine. However, once he found the grapes unattainable, he resolved the conflict between fact and desire by rationalizing that he didn’t really want the grapes in the first place. This thought undoubtedly comforted the fox.
I know it sounds like psychology mumbo-jumbo. But all investors and traders are continually tempted to behave just like Aesop’s fox. The natural reaction to cognitive dissonance is one of the main reasons all investors, yours truly included, have fought the proverbial tape at one point or another in their investing careers.
One common way traders attempt to reduce dissonance is to collect additional data points to support their preconceived view and outweigh contradictory evidence. For example, it’s possible to identify scores of obscure data points to back up almost any economic outlook if you care to look hard enough. The resulting data overload would be enough to drown out any dissonant hypotheses.
And I’ve personally witnessed individuals twist and spin fundamental and technical rationalizations to confidently predict an imminent trend change in a particular stock or index. These enthusiastic predictions often continue, even as their positions deteriorate and when a dispassionate examination of the fundamental data continues to point in the opposite direction.
The real danger is that by actively seeking out evidence in support of an existing opinion, you can gain a level of extreme overconfidence your opinions.
In other cases, you’ll hear investors try to rationalize incorrect opinions by blaming the actions of third parties–speculators, short sellers, Wall Street analysts, the ubiquitous group of ne’er do wells known simply as “they” are all culprits, for propping up the stock to window-dress returns, manipulating the oil market, etc.
Another mechanism to reduce this mental conflict is to seek out people with similar opinions and/or belittle those with opposing views. Early in my investing career I was, like most investors, bullish on the market and used to detest reading bearish commentary because it conflicted with my own beliefs. Now, when I’m bullish I actively seek out and read commentary from market bears I respect.
The truth is there’s no way for any human being to entirely eliminate emotion, sour grapes and cognitive dissonance from their investing or trading decisions. And most investors have a bullish or bearish bias surrounding the stocks or industry groups they hold in their portfolio. Emotion is an ever-present enemy.
But one way to control the influence of emotion on your investment decisions is to identify a set of indicators or data points with a reasonable track record that you’re willing to follow consistently. One of the indicators I follow is the Conference Board’s Leading Economic Index (LEI).
The LEI has helped me resolve potentially costly problems of cognitive dissonance on several occasions. For example, in late 2007 I had a bullish market bias; after all, the S&P 500 was just coming off an all-time high, and economic conditions were still reasonably solid. But deterioration in the LEI in late 2007 convinced me to start to position for a recession in January 2008. At the time, there were plenty of data points that suggested continued growth and further upside for the market.
There were also plenty of economists calling for the US economy to skirt recession or see only a shallow downturn. Of the few who forecast a severe downturn, many had been making the same basic prediction for years; being too early can be as costly as being too late to the party. It wasn’t necessarily the most comfortable position, but the LEI helped me cut through the noise and inconsistencies and become more cautious on the market.
Today I see many investors facing a similar cognitive dissonance: fundamental discomfort with the direction of the US economy and public sector finances, coupled with seemingly contradictory growing evidence of a cyclical recovery. I share that dissonance.
I have serious concerns about the direction and long-term trends in the US economy. I recently highlighted the risk of a spike in US and UK sovereign interest rates as foreign creditors become less willing to finance profligate government spending. Another risk that hits close to home for US-based investors is a surge in individual taxation.
The Congressional Budget Office (CBO) has been in the news a great deal over the past year; the CBO “scores” proposed legislation to see how it will impact the budget. The number most often quoted in the news is the impact of legislation on the US deficit. But the public spends far too much time focusing on deficits and not enough time looking at spending. Often predictions for a neutral or positive deficit impact simply reflect planned tax increases. Here’s a scary chart; it’s based on CBO projections.
Source: Congressional Budget Office
This chart shows that individual income taxes are projected to soar to new highs of nearly 11 percent of gross domestic product (GDP) by 2020. The last time taxes rose above 10 percent was 2000, when revenue surged due to the strong bubble-era economy. Revenues also surged in the late 1970s, one of the worst periods for the US economy since the Great Depression. Now, according to CBO estimates, we’re moving into unprecedented tax territory.
Scarier still, this chart doesn’t include the impacts of proposed new taxes such as those envisioned under the so-called health care reform bill. That list includes increases in payroll taxes for individuals earning more than $200,000 per year and couples with income more than $250,000 per year. The House envisions widening these taxes to include dividend and investment income (unearned income) for the first time instead of just wages and salaries. There would also be excise taxes imposed on certain health industries that would likely eventually be passed on to patients in the form of higher prices, a sort of stealth tax.
Were the CBO projections are updated to include these new tax proposals, US taxpayers would have a more realistic picture of Uncle Sam’s take in coming years. It’s not hard to see how the government’s total tax revenues–individual, corporate and other taxes–will rise to well north of 20 percent of GDP by 2019 from less than 15 percent last year. There’s no way to spin this as a positive for the US stock market or the economy.
But given this long-term negative bias, we have to fight even harder to remain dispassionate and to avoid rationalizing our positions. I’ve heard countless investors rationalize their lack of participation in the big 2009-10 run-up in stocks by saying the rally isn’t “real.” Others have attempted to dismiss indicators like the LEI as irrelevant this time because of the major structural differences between the US economy now compared to its shape entering and emerging from prior downturns.
One thing is for sure: Long-term negative biases aside, profits you would have earned in the stock market over the past year are very real, whether you care to denominate them in dollars, euros or gold. The short-term and long-term trends don’t have to be in agreement.
The LEI continues to point to more upside for the economy, and that’s largely supportive for a further rally in stocks. The LEI rose another 0.1 percent in February despite several extraordinary headwinds. For example, the largest negative contributor for the month was the average workweek for production workers; however, hours worked was heavily influenced by the extreme weather conditions experienced across much of the US throughout February.
The LEI is now higher by 9.5 percent year over year. Year-over-year comparisons will deteriorate over the next few months as we lap the extremely weak readings of early 2009. However, this is normal at this stage in the cycle and doesn’t reflect a weakening of economic conditions. The year-over-year change in the LEI will, by definition, peak relatively early in a recovery because the comparisons are easier.
What I will be watching for is persistent weakness in monthly LEI data or, most importantly, a fall in the year-over-year change in LEI below the zero line. This would indicate real trouble ahead but is likely months away.
Another Conference Board indicator, the coincident economic index (CEI), continued its own upward trend with the most recent data, rising another 0.1 percent.
Last but not least, the lagging economic index, which comprises seven indicators that tend to lag the economy by several months, rose 0.3 percent in February. This is the first positive monthly change in the lagging index in over a year and is further evidence that the US economy hit bottom and began to recover in the summer of 2009.
Keep playing the upside in stocks while it lasts. After all, you’ll need those profits to pay all the new taxes Washington has in store. It’s also time to start looking for income-producing investments that offer tax advantages.
I make no secret of the fact that master limited partnerships (MLP) are among my favorite tax-advantaged groups. MLPs offer yields as high as 10 percent coupled with significant tax-deferral advantages.
MLPs aren’t just boring low-growth companies; some have benefitted from rapid development of unconventional US gas reserves. In fact, in the service I co-edit with Roger Conrad, we recently recommended taking profits in Williams Partners LP (NYSE: WPZ), an MLP that soared 118 percent since our July 2009 recommendation.
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