In the 1950s, Stanford psychologist Leon Festinger developed the theory of cognitive dissonance, describing the psychological conflict that results from holding two opposing beliefs or attitudes at the same time. When subjects were asked to convey or act on information that they knew was untrue (and were provided only weak justification for doing so), the resulting “cognitive dissonance” actually led them to change their own beliefs and attitudes to be consistent with the untrue information. It is difficult to hold opposing beliefs simultaneously. Festinger later showed that people typically respond in two ways to cognitive dissonance. Either they try to preserve their current understanding of the world by rejecting or ignoring conflicting information, or they abandon their existing beliefs to reduce the conflict.
Several years of persistent yield-seeking speculation provoked by zero-interest rate monetary policies have created a fertile ground for cognitive dissonance. On one hand, any observer with historical perspective knows not only that the overvaluation from this kind of speculation inevitably ends in tears, but also that the heavy issuance of newspeculative and low-quality securities during the bubble finances and enables unproductive malinvestment that leaves the economy far worse off in the end. We should recognize that this same narrative was observed in the late-1920s bubble crash, in the tech bubble crash, in the housing bubble crash and will be remembered painfully, but in hindsight, as the QE bubble crash. On the other hand, prices have been advancing.
It’s difficult to entertain both of those facts at once. One must simultaneously hold in mind reckless yield-seeking speculation, hypervaluation that rivals the 1929 and 2000 equity market peaks (see Yes, This is an Equity Bubble), zero interest rates, low prospective long-term returns all around and persistent malinvestment that poses increasing systemic risks for the entire global economy, plus one fact that encourages us to forget it all: prices have been going up. Cognitive dissonance tempts us to reconcile this tension by ignoring one part of the story or another.
For bulls, this cognitive dissonance creates the temptation to ignore the speculative risk and to dispense with valuation concerns by citing measures that have weak or zero historical relationship with actual subsequent market returns. The result is a stream of justifications for why stocks are reasonably priced and likely to advance without interruption. For bears, this cognitive dissonance creates the temptation to ignore the rising prices – to plant the valuation flag, knowing that a century of evidence on reliablevaluation measures supports the strong conviction that market returns over the coming decade will be dismal (most likely negative over horizons of 8 years or less), and that the likelihood of a market loss on the order of 40%, 50% or even 60% in the next few years is quite high.
While we’re generally assumed to be in the second camp, I’ve done my best over the past year – particularly since June – to articulate our actual response to this cognitive dissonance. See in particular Formula for Market Extremes, Air Pockets, Free Falls, and Crashes, A Most Important Distinction, Hard-Won Lessons and the Bird in the Hand and The Line Between Rational Speculation and Market Collapse.
The best way to characterize our response is that it treats valuation extremes in a conditional way, which allows us to reconcile the full historical record without discarding inconvenient information. As I noted last week, what this framework requires, primarily, is the ability to withstand the cognitive dissonance of markets that are outrageously overvalued or undervalued, but persist until subtle deterioration or improvement in observable market internals and credit spreads indicates a shift in investor risk-preferences. When one faces two truths that are seemingly in opposition, the proper response is not to discard one of those truths, but to find a unifying principle that allows one to accept both truths at once.
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