WEEKLY MACRO NOTE - Human Biases

CONTENTS

• HUMAN BIASES

• WEEKLY WRAP UP

• LIQUIDITY MODEL

• SENTIMENT

• CORRELATION MATRIX

• ECONOMIC CALENDAR

• EARNINGS CALENDAR

• THE ROAD AHEAD

HUMAN BIASES

Until the advent of behavioural economics, it was generally assumed that humans were rational decision-makers, who accurately assessed the utility of alternative outcomes and generally made the most logical and economically beneficial choices.

In reality, we are not statistical processing machines, instead, we are highly biased decision-makers, driven by emotions, instincts and other forces.

Let’s look at some examples.

Try to answer the following questions posed by Kahneman & Tversky in their studies on human biases.

Chances are, that you opted for a sure gain of $3000, like 80% of the respondents to the survey did.

This defies the idea that we make decisions seeking the most economically beneficial outcome, but before we examine why, let’s look at a different question.

Chances are, that you would take the gamble and opt for the first option, probably reasoning along these lines “If I’m going to lose $3000 anyway, I might as well take the gamble”.

You are not alone, 92% of respondents answered in the same way.

Notice a few things. The two questions are essentially the same but mirrored. In the first instance, we were inclined to opt for the sure gain of $3000, and not bother with the chance at a little more. In the second instance, when faced with the certainty of a $3000 loss, we opted for the gamble, even if it meant we were likely to incur an even greater loss.

As the opening quote states - we tend to be risk averse in choices involving sure gains and to be risk seeking in choices involving sure losses.

Equally curious, to how we make the exact opposite decision whether we are faced with a gain or a loss, is that both answers are technically speaking the least economically beneficial.

By simple probability, in the first instance, our two expected gains are
80% x $4000 = $3200
and
100% x $3000 = $3000
Over time, the better payoff would come from choosing the gamble as
$3200 > $3000, yet we opt for the certainty.

Let’s reverse it and look at the expected values of the losses.
80% x $4000 = $3200
and
100% x $3000 = $3000
Curious how in this instance we chose the gamble, which is also the option which would prove to be the most costly, as a loss of $3200 > $3000.

As investors, in a game which can only generate a positive payoff if over time we turn the odds in our favour, understanding this key bias is crucial, as we are instinctively likely to make the wrong economic decision.

Turning the odds in our favour requires that in most cases we do exactly the opposite of what our biases incline us to do.

How often, when faced with a position which has gone against you, have you either bought more, to make back the loss sooner, or simply left the trade on, and determined that it is a “long-term investment”?

Conversely, how often when a trade has turned positive, have you booked that gain straight away, even if only for a small profit? And how often has that stock then just kept on marching higher to your immense frustration?

The point that we are intrinsically risk-seeking when faced with losses, and risk-averse when faced with gains, cannot be stressed enough, because reversing this, and having a mechanism that makes sure you do exactly the opposite of what you want to do, is probably the only way you will be able to beat the market by trading.

The most basic, and widely publicised rule of trading goes something like this “Cut your losers quickly, and let your winners run”. Incredibly, this seemingly simple rule is also one of the hardest to implement.

WEEKLY WRAP UP

The Bond market continues to be front and centre of the action.

The US 30Y Long Bond briefly exceeded 5% on Friday, on the heels of a very strong Jobs report. In September, the US added twice the amount of Jobs consensus expected.

The paradox continues to be that while economists and investors alike are focused on the ever-impending recession, the labour markets continue to be incredibly tight and resilient.

The volatility in the Bond market caused a spike in the Treasury volatility index MOVE >140, a level not seen since Silicon Valley went bust.

Stress is also returning to the European Sovereign Debt Market with the BTP to BUND spread (the difference in rates between Italian and German Bonds) breaching the 204bps level. This is a level which has previously prompted ECB intervention. BTPs are at the heart of the Europen Bond Market and a key source of collateral, but also the greater the spread the more politically problematic it becomes.

Even High Yield Spreads, which until recently had remained remarkably tight, widened by no less than 35bps WoW, a clear sign of some jitters.

I think what we are currently seeing in the bond market can be called climactic in terms of price action, with increased volume and volatility. Over each of the last two weeks, a record >200M TLT shares were traded. This equates to roughly 300% more volume than this year’s weekly average.

Does this mean rates can’t go higher? Absolutely not, and in the longer run they might, but right now, I think the bond market may be ready to offer some reprieve.

A key determinant of this will be the US inflation data this week. CPI is forecast to rise 0.3% MoM and decline to 3.6% YoY from 3.7% last month.

I think this should prove to be accurate, and I don’t think it will come in any hotter than expected. Note that Gasoline prices for example have been collapsing for week, despite higher OIL prices.

If this helps abate some of the pressures on the bond market, equities and gold should be direct beneficiaries, at least in the short run, given how strongly inversely correlated to rates they have been.

If this does not happen, however, there is every reason to be very cautious at this juncture. There have been two crises over the past year, the UK GILT crisis last Sept and the US BANK failures of this spring. Both were caused by the decline in the values of bonds, in other words, collateral.

Right now rates are even higher than they were on either of those occasions, so this clearly opens the door for issues to emerge.

If we shift our attention to equities we continue to see more of the same trend we have seen all year. Most equities were in fact down, but the Nasdaq closed up 1.75% on the week, while the SPX gained only 0.48% and the RUT was down -2.2%.

This was in large part due to the rally on Friday afternoon after the blockbuster jobs report. But the important thing to note is that the rally was led once again by the Magnificent 7 big tech companies, and every other sector languished.

For example, while the Nasdaq was up 1.70% on Friday, the RUT was up 1.18% and the Dow only 0.87%.

On the precious Metal front, GOLD fell to the key support level I outlined last week and rebounded about 20 points from there to close at $1830.

As it stands you have support at $1810 and resistance at $1950, a breach of either level will determine the trend from there.

One of the few calls I can say I have nailed this year is when it comes to $OIL.

WTI dropped from my key $90 level and was down about -10%.

So far, luck would have it that my $60 - $90 range shared at the start of the year has proven remarkably accurate, let’s see how it plays out with only 3 months left to go.

If only I had been as lucky with other assets…

I will say this on OIL, while my thinking was that we could see a bit more weakness into the mid-70s, this weekend’s events in Israel may change things. I am not an expert on these matters, but it does occur to me that with Iran supporting the attacks, if stricter sanctions were imposed on them, this could curb one of the recent sources of additional Oil supply, not to mention disrupt Nat Gas markets. Funnily enough Nat Gas was up 14% last week, I wonder if someone knew something…

LIQUIDITY

My liquidity model saw a little bit of a reprieve, although most of that came from RRP, and for it to be really positive for markets you want to see it come from either the TGA or Commercial Bank Balances, and that was not the case.

Meanwhile, the Fed & other Central Bank Balance Sheets continue to make new lows.

SENTIMENT

Market sentiment reached extreme fear levels not seen since October last year according to the CNN guage.

And bearish sentiment increased a tad to 41.6% per AAII

Asset allocators also took down their allocation once again.

While it is clear that sentiment has turned more bearish, and exposure to assets has been reduced, it also appears that Bears continue to use this decline to cover their long-held shorts.

• SPX shorts declined once again, and NDX Longs increased

• Dollar positioning is the major change, with traders getting longer the greenback, and a new short on the GBP emerging.

It is also worth highlighting that the Total Put/Call ratio, reached the highest level of the year on Thursday.

Curious how the Put/call ratio was higher now than during the banking crisis in March, although one interpretation could be that at the time many were already significantly bearish, while more recently investors were a lot more bullish meaning they had more stock to hedge, and hence the spike in Puts. This is just a guess.

My conclusion on overall market sentiment is that while this decline has caused a good degree of fear to return, and has brought a number of bears back to the Arena, there is still an underlying belief that markets will head higher, and we are nowhere near bearish levels seen at the start of the year.

CORRELATION MATRIX

EARNINGS CALENDAR

Q3 earnings season starts with some of the big banks on Friday.

ECONOMIC CALENDAR

US inflation data are the main events of the week.

THE ROAD AHEAD

Last week my best guess was that we would get one last flush before a squeeze, and indeed that is what happened.

As we enter next week, most of my attention will be on the VIX.

The front end of the VIX curve briefly entered contango last week, as the current contract was priced higher than the December one. This, coupled with all the Put buying, means that unless some event happens, to truly warrant those hedges, a lot of them will have to be sold, and this will provide supportive flows into equities. This is particularly important in this time frame, as it is the week before the Monthly OPEX, so the value of those puts decays all the faster.

There are always two sides to the same coin, and if an event does occur that triggers panic, then those options are all the more sensitive because of their proximity to OPEX and can create downward spirals.

Again, these are dynamics in these windows of time which we have already discussed and you should by now understand.

We have additional uncertainty thrown into the mixture as we enter next week, given the current situation in Israel.

For the SPX, 4350 is the next immediate obstacle, above that we flip the dealers into positive Gamma territory and the 20D moving average, which might help the market trade as far as 4400+.

On the downside, if you are a Bull you really don’t want to see any daily closes below 4250/426060, or the VIX back above >19 for that matter, as it would likely suggest lower lows will be in order.

Defence stocks such as LMT & RTX have taken quite a beating recently, this new wave of tension should help them find support and possibly catch a bid.

Lockheed Martin with a lower high at $400 may be worth a shot with a stop not far below, around 390.

RTX may present an even more asymmetric opportunity, given the recent beating it has taken due to some engine contract issues.

On another note, Footlocker stock, which I shared a few weeks ago at $17, is currently trading at $19.89. I think as long as it can hold $18.2, it should head to close this first gap all the way up to $24/25.

Meanwhile, General Mills, a stock I shared 3 weeks ago at $65, fell as low as $60 on Friday, before recovering the flush out and closing marginally up on the day at $62.49.

I do quite like this as a reversal candle, although I would like to see $66 recovered to confirm the trend reversal.

Have a great week,

Antonio