Is Euphoria a moral hazard?
Lance Roberts has a piece called Not Seeing Signs of Market Exuberance? Look Closer. He talks about the psychology of gamblers to expect winning even when the news is bad. He makes the connection to the stock market that traders keep pushing the market higher in spite of less-than-good news.
He then makes the connection to how monetary policy has encouraged the psychology of traders to expect more gains when bad news appears.
“The actions by the Federal Reserve to suppress interest rates and inject liquidity into the system have most definitely tilted the current “odds of winning” into the player’s favor.”
Did the Fed run the danger of moral hazard for a couple of years by building the foundation for euphoria in the stock market?
Currently reading John Coates, “The Hour Between Dog and Wolf”, about how our body chemistry and electrical system (stress response, ‘fight or flight’) impacts our decisions, including financial ones, especially if you’re a trader.
He wanted to test the “winner effect”, wherein male animals who ‘win’ a mating duel have higher testosterone levels, which continue to rise as they continue to vanquish their opponents. He wanted to see if held true for humans, and he used a group of traders to do so. Sure enough, the traders who made the most money had higher levels of testosterone, AND they got cockier (pun not intended) as the feedback loop progressed, until they entered a level of ‘irrational exuberance’, wherein they were almost blind to the risks they’d undertaken.
Coates discusses the dose-response curve, where, if testosterone levels continue to rise in animals who have been consistent winners, they reach a peak where they begin to take foolish risks. Surprise, surprise, so did the traders in his experiment. They went from being ‘in the zone’ to laying on riskier and riskier trades.
This, it seems to me, screams out a big “BS” to those proponents of ‘rational market’ theory.
Thanks for the great comment.
The winners are the ones who lead the herd too. The losers tend to follow the winners who end up taking irrational risks.
There have been months and months of traders winning. It is hard for them to accept that the market is stalling now. They lose their power based on their success of the past couple of years.
Thanks, Edward. What I am finding REALLY interesting is how much of our economy may, in fact, be based on biology, not rational thinking. I don’t mean to imply that we are totally at the mercy of our brain chemistry, but I do think we need to take it into consideration.
Since Coates had been a trader himself, before he decided to return to school and become a neurscientist, he’s seen ‘both sides of the street’, as it were.
When Wall St. traders start feeling “ten feet tall and bullet proof”, maybe we should all take cover. 🙂