Amid the best start of the year for the S&P 500 since 1987, Nic Colas of Con­vergEx offers some deep thoughts on how behav­ioral finance con­cepts can help us under­stand the dichotomy between last year's derisk­ing and this year's rerisk­ing in terms of mar­ket par­tic­i­pant psy­chol­ogy. Between delv­ing into whether a short-sharp or long-slow colonoscopy is 'prefer­able' Nic reflects (anti­thet­i­cally) on 10 bull­ish per­spec­tives for the cur­rent rally and how the human mind (which still makes up maybe 50% of cross-asset class trad­ing if less in stocks) processes dis­com­fort in very dif­fer­ent ways. Crit­i­cally, while it sounds counter-intuitive to him (and us), focus­ing on the pain of recent volatil­ity is actu­ally more con­ducive to investors' abil­ity to get back on the horse espe­cially when the acute pain is ended so abruptly (intervention).

Nicholas Colas, Con­vergEx. Hurts So Good

Sum­mary:

The best start to the year for the S&P 500 since 1987 makes the pain of last year’s volatil­ity feel just a bit more dis­tant. But at the same time it sparks the ques­tion: just how much pain do indi­vid­u­als even remem­ber? For­tu­nately, there is a grow­ing body of psy­cho­log­i­cal work on the topic, with some illu­mi­nat­ing lessons. Long bouts of pain that end with lit­tle dis­com­fort are far prefer­able to short sharp shocks. That sounds a lot like a Greek sov­er­eign debt default – long antic­i­pated and likely soon upon us. And hope­fully well enough fire­walled to pre­vent col­lat­eral damage.

Or con­sider that sub­jects who actu­ally focus on a painful expe­ri­ence while it is hap­pen­ing are more will­ing to imme­di­ately undergo fur­ther pain than those who per­formed some dis­tract­ing task. Which might go part of the way to explain­ing the market’s abil­ity to bounce back from gut wrench­ing – and closely exam­ined — volatil­ity. None of this assures a pos­i­tive out­come for the rest of the year, to be sure. But it does explain why investors can plow right back into a mar­ket that has been so tough for so long.

I enjoy assess­ing the cap­i­tal mar­kets through the lens of behav­ioral finance, but I have learned from read­ing scores of aca­d­e­mic stud­ies that you do not want to be a sub­ject in any exper­i­ment related to the dis­ci­pline. Ever. Here’s just two examples:

In a widely quoted exper­i­ment by Nobel Prize win­ner Daniel Kah­ne­man (with oth­ers, pub­lished in 2003) over 600 sub­jects under­go­ing colono­scopies were given dif­fer­ent ver­sions of the same pro­ce­dure. One set got essen­tially a short ver­sion, where the pain of the process peaked out near the end of the exam. The other group got a longer ver­sion, with the last few moments in rel­a­tively lit­tle dis­com­fort. The sec­ond group reported much less pain when asked about the expe­ri­ence than the first.

In another exper­i­ment, researchers from the Leeds Uni­ver­sity Busi­ness School (Read and Loewen­stein, pub­lished in 1999) took groups of sub­jects and paid them to place their hands in very cold water with the intent of inflict­ing mod­er­ate but pro­longed pain. One set of sub­jects were given a dis­tract­ing task, while the other group was told to focus on the dis­com­fort of the moment. Imme­di­ately after the process, the group that had noth­ing to dis­tract them was actu­ally more will­ing to undergo the whole thing all over again. But a week later, the dis­tracted group was the more amenable to repeat­ing the experiment.

There are other works in the cor­pus of lit­er­a­ture on the psy­chol­ogy of pain, but these two suf­fice to show that the human mind processes dis­com­fort in unpre­dictable ways. The first shows that how expe­ri­ences end is far more rel­e­vant to the mem­ory of it than the pain involved at the time, even if the over­all time spent in dis­com­fort is greater. The sec­ond shows (accord­ing to the researchers, any­way) that the mind actu­ally needs to focus on pain in order to get over it quickly. The ancient Bud­dhist advice about liv­ing in the moment turns out to be true even when the moment is painful.

I thought of these exper­i­ments in pain as I watched the U.S. equity tape yes­ter­day, mar­veling at what has become the strongest open­ing gam­bit for a Jan­u­ary since 1987. Not that there’s any short­age of bear argu­ments (more on that in a minute), but because it was actu­ally easy to sketch out a healthy list of near term pos­i­tives for U.S. stocks. In about 4 min­utes I jot­ted this “Top 10” list:

1) U.S. finan­cial stocks have bounced back nicely from year-end tax loss sell­ing, mak­ing it look (for the moment, at least) like investor con­fi­dence has returned to this belea­guered sector.

2) After a flush of excess enthu­si­asm for Q4 2011 earn­ings in the mid­dle of last year, ana­lysts have reduced their expec­ta­tions enough for com­pa­nies to meet them as we go through earn­ings season.

3) A lack of deadly Euro­pean head­lines, such as a failed auc­tion or +8% Ital­ian bond rates.

4) No hard land­ing head­lines from China.

5) A Euro that seems to be stand­ing on all four feet, even if genus and species of the ani­mal are as yet undetermined.

6) Rea­son­able val­u­a­tions for U.S. stocks, at least against the much-mentioned $100/share for S&P 500 earn­ings. And frankly even if they are $80/share.

7) A gag­gle of decent news from the U.S. labor mar­kets and con­sumer con­fi­dence.

8) Oil prices that have not mate­ri­ally lifted above $100 despite a hot civil war in Syria and a ruth­less cold war, replete with unabashed assas­si­na­tions, between U.S./Israel and Iran.

9) The expec­ta­tions for inbound money flows into U.S. equity mutual funds in Jan­u­ary from new tax year 401(k) contributions.

10) A rally that actu­ally started in early Octo­ber, did a pretty text­book reverse head-and-shoulders in Novem­ber and Decem­ber, and broke out about a week ago.

But what about the pain of the last three years, and the very clear prospect for more pain ahead? It would be just as easy, after all, to sketch out the Top 10 rea­sons (or 20, or 30) about why this rally is doomed to fail­ure. And while I don’t want to anthro­po­mor­phize equity mar­kets entirely – most esti­mates of daily vol­umes have carbon-based life forms respon­si­ble for less than 50% of daily activ­ity – the pain stud­ies I noted above can help put the S&P 500’s rally into con­text. Two thoughts:

Kahneman’s colonoscopy is a tai­lor made, if coarse, anal­ogy to the ongo­ing sov­er­eign debt woes in Europe. Both are unpleas­ant, and both have gone on for a long time. But recall that how painful inter­ludes end is crit­i­cal to how patients, or investors, recall their expe­ri­ence. If Greece’s seem­ingly inevitable default in March (and poten­tially sub­se­quent ones else­where) can move smoothly, then the end of this par­tic­u­lar chap­ter may resem­ble the pro­ce­dure that Kahneman’s sub­jects found less painful.

While it still sounds coun­ter­in­tu­itive to me, focus­ing on the pain of recent volatil­ity is actu­ally more con­ducive to investors’ abil­ity to get back on the prover­bial invest­ment horse. Granted, the money flows out of mutual funds last year shows that this phe­nom­e­non, if it is hap­pen­ing, is not cen­tered on the retail investor. But asset allo­ca­tors such as those that man­age pen­sion funds are just as human, and it is likely this camp that is push­ing money into equi­ties the last few months. And there is good rea­son for them to do so, with assumed rates of return for such funds still +7% and U.S. Trea­suries yield­ing only 2%.

The bot­tom line is that pain, like beauty, is in the eye of the beholder. And the way that eye views a painful expe­ri­ence is a crit­i­cal vari­able in how its asso­ci­ated mem­ory records it. The mar­kets have been to hell and back in the past 3 years. But if (and a big “If” it is) pol­i­cy­mak­ers and politi­cians can cre­ate some bet­ter out­comes in the com­ing months, then investors’ mem­o­ries may not only focus on the pain but actu­ally shift more per­ma­nently to the positive.

We agree that behav­ioral finance does indeed have plenty to teach mar­ket par­tic­i­pants but our ear­lier dis­cus­sion of the ever-slowing vol­umes in equity trad­ing make us won­der if we are merely culling the uni­verse of par­tic­i­pants to the high­est pain-threshold-capable (read TBTF funded) or shortest-time-frame-capable (HFT obvi­ously) with the rest of the US invest­ing pub­lic is in the mid­dle hav­ing their net worth whit­tled away by the swings.

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