The data miners are out in force in recent weeks trying to compare 2011 to 2010. We’re seeing endless chart overlays with excessively simplistic analysis that says 2011 = 2010 because of XYZ. In the world of cognitive science this attempt to compare everything to recent events is called the recency effect. It’s particularly pervasive in the stock market as we are always attempting to decipher future events by past actions. We have a tendency to believe that the market’s recent actions are likely to repeat themselves even though the market is a dynamically adapting non-linear system. You see it on a daily basis in the markets. The only problem is that it will almost always lead you astray.
Understanding the past is vital in building a sound understanding of macro trends. After all, Mark Twain was right when he said that history may not repeat, but it does tend to rhyme.* And when it comes to big broad macro trends that is particularly true. I’ve utilized the Japan playbook for much of my understanding of the current economic environment. And it has worked. The problem is, this doesn’t always translate into an ability to understand where the market is going. The market after all, is not the economy.
The reason why this recency effect is likely to lead you astray more often than not is due to the fact that markets are just a microcosm of the global economy. Therefore, understanding what the market did in 1937 during the Great Depression is not likely to help you decipher what the market is going to do in 2011. Why? Because the micro picture is entirely different. There might be similarities between the two environments and you might be able to glean very valuable insights from the macro picture by understanding what occurred in 1937, but the equity market of 2011 in no way resembles the equity market of 1937.
The same can be said of the recent attempts to compare 2010 and 2011. The primary problem with these comparisons is that they are not apples to apples. Instead of in-depth analysis we are generally seeing YTD charts with labels such as Jackson Hole, the recent sell-off and an emphasis on the spectacular year-end rally in 2010. The thinking here is even more simplistic than that though. Investors utilizing this comparison are prone to believe that the Fed is able to once again save the equity markets via a policy response. But this assumes that the market is not dynamic, not adaptive and linear – things it is not!
The problem here is that the market environments are entirely different and the lessons of the past have now been built into investor behavior in a fashion that actually makes the current system even more dynamic than it was in the past. And we see this difference in many other markets which are confirming that this is a different animal from 2010. Whether it be high yield bonds, CDS price action, sovereign debt markets, interbank lending markets, etc. They are all telling us that the credit markets are FAR more strained than they were in 2010. The animal we think we know in 2011 is far more concerned than the one we knew in 2010. And that alone makes this a very different beast. And while it doesn’t hurt to understand the creature of 2010, relying on it to behave the same exact way it did last year is likely to be misleading.
In sum, investors are prone to oversimplify their analysis by referring to technical analysis while combining this with recent events in order to try to explain the future market action. This recency effect, more often than not, is proven false when one looks under the surface and better understands the comparison and understands that the market is not a simple linear system. This recency effect leads investors to establish strategies and beliefs that are excessively simplistic and likely to fail. But if an investor better understands the complexities of the system and its ability to adapt and evolve, that investor can better prepare him/herself to conform to the changing environment and create a strategy that is more appropriate given the ever adapting marketplace. In short, adapt with the adapting market or die.
* Updated with proper Mark Twain citation.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.