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June 12, 2017

The Market Sentimentalist – Who’s Eating Porridge?

by Amareos.

Question: What is one thing (in no particular order) behavioural psychologists, filmmakers, journalists and advertisers all understand?

Answer: The power of the narrative; humans like stories.

Before the written word was invented, sitting round the campfire at the end of the day telling and retelling tales was how humans conveyed knowledge to each other (and passed it down through the generations): we are genetically predisposed to stories, tales, narratives – call them what you will. We find them an incredibly useful device for processing and storing information. Indeed, many memory-boosting techniques recommend turning data lists into stories in order to improve recall.

If you want someone to remember something start off with these four magic words…

“Once upon a time…”

However, as is often the case, our genetic inheritance, important while it may be from an evolutionary standpoint, can be an impediment when it comes to analyzing financial markets. Indeed, this particular example is known as the narrative fallacy, neatly defined by Nassim Taleb as…

“…our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense.”

Our genetic predisposition to a compelling narrative can fool us into misjudging the underlying reality of a situation. Worse, the more people who believe in the story, the more powerful it becomes[1] – a case of proof by repeated assertion, something that occurs with alarming frequency in economics and finance.

The post-Trump reflation theme is a great recent example of a compelling narrative that was largely divorced from underlying macroeconomic fundamentals. Despite Trump’s lack of experience in political office, meaning he was very much an unknown quantity[2], the crowd quickly concluded that his stimulative fiscal policies would be enacted generating a strong reflationary impulse. This is clear by observing how future US inflation sentiment surged immediately following his election victory (the rise was unprecedented in magnitude over the 11-year history for which sentiment data are available[3]).

Exhibit 1: Amareos Tweet – January 6, 2017


Consistent with this perceived change in crowd thinking about the US economic outlook, Treasuries tumbled (10-year nominal Treasury yields jumped over 70bp[4] in a matter of weeks) and US equities gained over 7%. A classic equity/bond cyclical asset allocation rotation was underway.

Since then (mid-January), the Fed has signalled its intention to continue raising the target funds rate (odds of a hike next week stand at 80%) while also flagging the prospect of scaling back its bloated balance sheet. Over the same time frame, US equity markets have continued their ascent to record highs (16% since election day) despite their increasingly obvious richness[5].

In light of these developments it would not be unreasonable to expect the uptrend in US bond yields to have continued[6]. But, this is not how things have played out. Nominal Treasury yields have been rather directionless over the past several months – flat to modestly lower depending where upon the maturity spectrum one looks.

So what changed?

The narrative changed. Updating the chart contained in exhibit 1 we can see a complete reversal of future US inflation sentiment since the mid-January peak. The Trump reflation narrative is well past its sell-by-date, and it has been this shift in mood that has benefitted bonds.

Exhibit 2: Future Inflation Sentiment – US


Such divergence between US bond yields and equity prices has prompted some serious head scratching among investors as to what it means for the US economy – and hence by extension – the future direction of US (Global?) asset markets. The tension arises because the increase in US equity prices suggests a more constructive macro outlook, while the pull-back in longer-dated bond yields (the declining term structure as well as the outright yield level) suggests something less constructive.

One possible explanation for the apparent bipolar behaviour of US financial markets is that one is right and one is wrong. But which one is it?

Macroeconomic bears (let’s label them Papa Bear[7]) are keen to point out that since the election US “hard” macro data never really showed much improvement. The gains were almost exclusively in the “soft” survey data and this has now rolled over. Moreover, the yield curve typically flattens ahead of decelerating US economic growth (the 2s/10s curve going negative is a reliable US recession indicator – currently the spread stands at 113bp).

The perception that bond markets tend to be more forward-looking than equity markets suggests the risks are skewed to the downside for the economy and that US equity markets are ripe for a major correction[8].  A tempting conclusion is that, as we noted in a previous Market Insight and reiterated above, US equity valuations are historically “rich” – something that has equity bears (Mama Bear to continue the analogy) salivating.

However, as we also pointed out, in addition to overvaluation, a further hallmark of a major market top is excessive crowd sentiment – it is the fuel for irrational investor behaviour. So far at least, this element is missing with the latest readings of crowd sentiment towards US equities only mildly positive (social is more constructive than mainstream media which is very neutral).

Exhibit 3: Crowd Sentiment – SP500


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That said, while US equity market valuations appear stretched, bond bears (let’s call them Baby Bear) are just as eager to point out that US government bonds are very overvalued. A 10-year nominal Treasury bond yields just 2.2% and the equivalent TIPS yield is a miserly 52bp. What’s worse, TIPS are indexed to headline CPI, whose annual rate as well as being more volatile than the core PCE deflator which the Fed targets is, on average, 20-30bp higher. Hence, generating even this low real return will require the Fed to continue to undershoot its inflation target – something it is not deliberately aiming to do[9].

For Mama Bear (equities) to be right and the Baby Bear (bonds) to be wrong requires a very dire macroeconomic environment – decelerating economic growth (very probably a recession) and a strong disinflationary/deflationary undertow.

Conversely, for Mama Bear to be wrong and the Baby Bear to be right requires strong economic growth and rising inflation (revisiting the post-Trump narrative).

For both Mama and Baby Bear to be right – a scenario that terrifies Risk Parity funds – we need a combination of weak economic growth and rising inflation – a “stagflationary” environment that causes havoc because rising inflation would force the Fed to stamp on the monetary brakes, signalling an end to the Greenspan/Bernanke/Yellen put[10].

We agree with many others that the simultaneous overvaluations of US equity and government bonds generates a distinct “instability” aroma – one equity and bond bears are both itching to exploit – but it is still far from clear which of the above scenarios will play out, or when. Moreover, when we look at crowd perceptions of US economic growth we find something rather interesting.

Exhibit 4: Crowd-sourced Sentiment Economic Growth – US


The crowd may well have given up on the inflation component of the post-Trump reflation narrative, but is has not given up on the growth component. US growth sentiment has stabilized well into in positive territory indicative of confidence that the US economy remains in moderate expansion mode. The crowd perceives economic growth as being neither too hot nor cold and there to be no imminent inflation threat.  There is, in other words, something for everyone. This perception of a moderate economic expansion/subdued inflation mix is not restricted to the US, it is apparent across much of the globe as the two heatmaps shown in the exhibit below confirm.

Exhibit 5: Economic Growth Sentiment – Global


Exhibit 6: Future Inflation Sentiment – Global


Papa, Mama, and Baby Bears all have plausible stories to tell, and something could materialize that jolts the crowd’s current viewpoint. But, until that happens, they will have to wait patiently on the sidelines for validation – it could be a long wait – because the post-Trump reflation story has only partially morphed. It is now a childhood classic that begins…

“Once upon a time, there was a little girl named Goldilocks.”

Pass the spoon!

Amareos sentiment analytics are based on MarketPsych indices. 


Amareos crowd-sourced sentiment indicators are based on MarketPsych Indices


[1] This is tied up with the concept of common knowledge – see:

[2] Many would, justifiably, argue he still is –  “Covfefe” anyone?

[3] In the January 6 Tweet we only included data back to January 2010 but it is available at a daily frequency back to January 2005.

[4] At the time the surge higher in US Treasury yields reinvigorated bearish predictions that the long-awaited pricking of the bond market bubble was at hand in barely a month. Bond bears are even more tenacious in their views than equity bulls. Indeed, anticipating the reversal of a 30-year bull market in government debt has been one of the more consistent forecast errors over the past several years.

[5] See:

[6] As we noted in the last Market Insight of 2016, many investors anticipated this being the key trend in 2017 – see:

[7] You can probably guess where this is going, if not, it will become apparent.

[8] By major we are referring to a correction of more than ten percentage points.

[9] If the Fed did manage to hit is inflation mandate the real 10-year Treasury yield would be approximately zero in headline CPI inflation terms, which is surely the most pertinent inflation measure for anyone who eats and/or uses energy – ie, is alive.

[10] That said, we are far from convinced that such a scenario would play out in this manner for any length of time. Central banks have invested a great deal of effort warding off the Great Recession hangover and faced with a choice of maintaining their inflation targeting objectives or presiding over a substantial growth-toxic simultaneous re-pricing of equities and bonds, we strongly believe the inflation target would be sacrificed putting us in a brave new financial world (but one where there is precedent).


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