Tag Archives: risk premium


You all already know where I think this market is headed. However, the twitter streams are full of folks that are ready to declare yet another rally to new higher plateaus. Most investors don’t seem overly concerned about things. I certainly have not detected any real panic in either the sentiment readings or in the price action of the market.

There are still some pretty serious technical issues afflicting the market that have not been alleviated by the recent pullback. A myriad of indicators such as Put/Call ratios, Bullish Percentage indicators, volume studies, et cetera, are indicating weakness to come. I believe that the path of least resistance is to lower prices, and that the process has begun. Those are my personal opinions however, and that plus $3.50 will get you a Grande Soy Latte at Starbucks.

Anything is possible short term in this era of daily Central Bank injections of “monetary morphine” in the form of POMO. This stock market “crack” is in essence creating yet another asset bubble, this time through mispriced risk premiums in both equities and bonds. The chase for yield in a lower bound interest rate environment is the catalyst, but that is not the topic of today’s post.

You see, bubbles can go on for longer than even the most stubborn contrarian may be able to wait. Timing such reversals is treacherous at best and suicidal at worst. That’s not my point either. My topic du jour is of the incredibly obvious, yet to-date not talked about fact that the Fed’s open market operations since 2009 have created a unique moral hazard. This will act as dry tinder to the next real correction in the markets, whenever that may happen – and it WILL happen.

In the study of Psychology there is a theory of operant conditioning that was formulated by B.F. Skinner. Skinner’s theories were based on principles such as reinforcement, punishment, and extinction. Skinner created experiments using rats that would provide positive and negative stimuli creating learned behavior responses.  His Law of Effect was in essence that responses producing a satisfying effect in a particular situation become more likely to occur again, and responses producing a discomforting effect become less likely to occur again.

I would argue that the Fed has done the same with us folks in the investor class. Just like rats we are conditioned that buying any dip no matter how small will be rewarded with profits. Conversely, selling stock short or betting on stock prices to fall will be punished with severe losses. This keeps the herd moving in the same direction, but it inflates the bubble higher and higher. This learned behavior response is manifested in two phenomena currently observable in today’s financial markets: BTFD and Pavlovian Short Covering (let’s call it PSC for shorthand). Unless you have been underneath a rock in the fetal position since 2009 then you already know what BTFD stands for, but if not I’ll tell you here.

BTFD stands for Buy the Fucking Dip. The first time I saw it referenced was in a YouTube video that appeared at least a few years ago. Since then, BTFD has become somewhat of an accepted truth. After all, anybody that has bought ANY dip of ANY size over the last 4 years has made money with very few exceptions. BTFD has certainly made many of its disciples very rich and that is one of the strongest positive reinforcements a human can receive. Not only does it reinforce the behavior in the initial participants, but it has created a tractor beam of groupthink. As more and more people have benefited from the learned behavior, the strength of belief has spread far and wide and its practitioners have been emboldened.

The flip side of the reinforced behavioral response is Pavlovian Short Covering. This is the act of reflexively covering short positions at the first sign of a return of strength to the bull side. This learned behavior is based on negative stimulus exerted upon bears time after time over the last 4 years. The tactics used to elicit this PSC is mainly through extreme, and some would say purposeful, manufactured violent short squeezes. Often these bear traps are sprung in the dead of night. Index futures rise in overnight trading creating a rush to cover short positions into the opening bell. Other times at key moments when the market is threatening to roll-over, there is an almost “magical” news item that comes out creating the squeeze. Sometimes, there’s no news at all, but a certain mysterious “hand of the Patron Saint of Bulltards” comes in and ramps the futures from certain failure. This hand of God typically lifts price up and past key areas where bears generally cover their short bets to avoid further and certain excruciating pain.

Any and all of these scenarios trigger PSC, and once it begins, a feedback loop comprised of weak handed short sellers and conditioned dip buyers combine into a glorious symphony of Federal Reserve operant conditioned rats.

Now this is all fine and good until somebody pokes an eye out. This conditioning is based on experience and results that have been extremely effective in the bull-run off the 2009 S&P lows. At SOME POINT however, (I would say that point has already arrived, but some will disagree) the trend changes, and the great Bernanke Bubble pops.

When this happens, the extreme conditioning response cultivated over the past 4+ years will serve to exacerbate the eventual declines. Initially bulls will not sell their positions when the market weakens and may instead continue to aggressively buy the dip. After all this has worked like a charm in the past – why change now? Bears on the other hand, gun shy and wary of all of the relentless traps, will not be eager to short, thus creating no fuel for squeezes.

Combine all this with the fact that there are currently many crowded trades due to the narrowing participation of stocks to the recent rally (see Market Halitosis for more on this). If things turn south the low volume on the exchanges will make declines more severe. Also, there is the very real possibility that if things get really ugly then the High Frequency bid will evaporate, further lowering liquidity. Thus the unique set of stimuli creating these learned responses will eventually be the fuel that enables real conflagration to erupt. This will be the point that everyone realizes that the new phrase to learn is STFR or Sell the Fucking Rip.

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