Dr. Emery
This post is opinion only. See full disclaimer below.
This paper is a preliminary release intended to advance my broader argument. Specific analysis; sources and references remain subject to revision and correction.
First of all, methodologically this is a qualitative not quantitative framework of asset bubble behavior using the small n empirical approach of such writers as Theda Skocpol and Barrington Moore, although applied here to very different conditions and variables indeed than were their concerns. Its goal is to provide an approach through which actionable trading decisions can be made in real time regarding the risk-reward issues surrounding rapidly escalating asset valuations. It has broader analytical significance, but it is meant to first and foremost have utility in providing alpha.
The approach is meant to provide nuanced assessments of what I believe to be they key causal factors in bubble creation and crashes: intentional narrative creation, not accidental market sentiment, and views of traders about market weighting. Can this be quantitatively tested? Perhaps, but just as group psychology at a higher level as a whole does not lend itself to simple quantitative analysis it is my initial opinion—subject to change—that qualitative assessments are far more useful.
The model ultimately involves a qualitative rating of two sea-saw phenomenon on a scale from -6 to 6 regarding the extent to which the markets for an asset class have embraced and become totally infatuated with a particular over-arching market narrative or has failed to or subsequently taken flight from this narrative, and the extent to which traders are either leveraging up and encouraging through market behavior the narrative or abandoning or going short such a narrative.When these two positive bubble factors are absent but no negative factors are present a score of 0 would be the case. When market sentiment and positive trader action and leverage is at maximal velocity a score of 12 combined would occur. In the midst of a full out crash in which trader action and group psychology are in their maximal negative position the combined score would be -12. Many other combinations are possible all with various likely market outcomes and changes in direction would also prove crucial. One can think of these 2 scales as see-saws going back and forth with various states of disconnect or equilibrium. These judgements occur on a continuum based on a deeper appreciation of the underlying dynamics involved and comparative study–they do nor represent a simplified numerical score as such. More on the details of this and different patterns in a later note.
I have argued recently for what I have termed the Macro-political Captured Asset Hypothesis (MCAH) for understanding markets and assets more broadly in contradiction to Eugene Fama’s Efficient Market Hypothesis (EMH). The GPTA model is not an alternative to MCAH which is still my overall approach. Instead it should be read as simply elaborating another key component of market capture in this case not by political power or illicit capital or even state power as such, but instead by those market actors who seek to capture the markets through either political narrative construction or trader action. I say “political” narrative because in my mind such narrative construction is extremely intentional and concerns power as does trader behavior regarding it. .Bubble power when it occurs is still in many ways less important than broader, more general political power overall for asset value. This is obvious in the very broadest sense since, for example, assets are extremely differently valued under feudalism or capitalism or under communism. However, on a smaller and more useful historical time frame either bubble power or general political power can capture and control assets and markets. The degree Bubble power dominates markets as a whole is always an important question, but under extreme circumstances, especially, behavior precipitating a potential crash, GPTA becomes, at least for a while, the most important thing investors must understand if they wish to preserve capital and generate alpha.
Let me, before detailing the key premises of GPTA, say a few words about one of the better accounts of bubble behavior and crashes, Gary Shiller’s work on irrational exuberance. In some areas there is overlap between GPTA and Shiller’s theory, and I certainly believe his work was deserving of a Nobel Prize. But the GPTA model differs strongly from Shiller’s approach in several key respects which will be discussed more fully also in later notes. Let me just say here, that first, GPTA does not like Shiller view irrational exuberance as a broad multi-causal event in which retail investors simply got some misguided ideas about markets and things like the media incorrectly amplified those mistakes. On the contrary, we believe that the process of creating market narratives is incredibly intentional and involves power. It is not a mistake in rational calculus, it is a purposeful creation of certain non-rational group states which is an entirely different matter indeed! If Shiller had made this clear his approach might have been too contentious and perhaps he wouldn’t have won his Nobel Prize. Second, we believe trader action is equally deliberate overall and has the goal to capture as much of the flows generated by narrative as possible in what the participants view as a zero sum game. Put simply, Shiller’s account while certainly interesting and worthwhile assigns to retail investors the most “rational” irrational motivations imaginable in part because of his conventional “rational actor” economic starting point, whereas GPTA starting from an entirely different inter-disciplinary understanding of such non-rational behavior and provides, I believe, a more useful perspective. And Shiller’s work whether intentionally or not completely covers over the very real and dominant power machinations involved in Bubble power. But most of all it really fails to adequately explain the psychological mechanisms involved and the specific trigger that causes crashes. As such it stops short of articulating the key deeper mechanisms that GPTA addresses.
With all that said, and thank you for bearing with the account,, on to a few of the essential premises of the model and a first glance at the overall approach:
Premise 1
Markets are under certain circumstances and in essential ways controlled by narratives the goal of which is to get investors to overbid valuations and drive flows of capital into assets. Such narrative construction to get potential buyers to consume assets occurs, of course, all the time in various “sale pitches” and in the classic stockbroker cold call narrative. In this case, however, we are talking about top tier narrative creation by powerful interests intended to move 100s of millions of perspective clients and ultimately billions and even trillions of dollars of capital.
New narratives are constantly paraded before the investing public all in an effort to capture markets and most are extremely short lived and unsuccessful. When the market, however, finds a broad narrative that can meet this objective and clients respond as desired countless participants with a strong power interest in the ascendency of such a narrative jump on board. This includes various media interests.
The key though,, as already alluded to, is that this is not a random outcome of a thousand accidental causes but an orchestrated event whether indirectly or directly that serves the interests of power. The examples of such ruling asset narratives should be obvious. In later posts we will look at key instances comparatively.The two recent examples, of course, of such a narrative in recent years were the tech bubble of the late 1990’s and early 2000’s and the housing bubble of the mid-2000’s. AI may be a current day example although there are some key confounding factors.
Narrative power is an independent variable that needs to be analyzed on its own terms. Also let me be clear that such narrative creation for assets occur by individuals across the ideological spectrum and are not the exclusive province of either the left or right of the political spectrum.
Premise 2
Nothing could be more important for a sufficient bubble model than understanding the specific group psychology that is created by such a narrative when it comes to dominate a market and asset class. The creation of this specific psychology might in fact be the key goal of the narrative makers. Some of this psychology therefore may be said to be imposed from above, so to speak, by the powerful, but at the same time this is an interactive process and the group itself can, once the spark is lit, take the narrative in its own distinctive directions. Its even possible that the need for a narrative in the first place comes actually from the non-rational predilections of the broader group and elites only respond to increase power in the way they do because of these group constraints. Theorists of group psychology divide fairly evenly on either side of this key chicken or egg first question of whether leaders simply impose the state or are forced by the group to do so if they seek power in a particular manner. In either case, however the process is ultimately intentional on the part of those elites responsible.
The key to all this is that the group psychology once active takes the form brilliantly described by one of the key founders of group therapy W.R.. Bion as the dependency group non-rational assumption, or in his notation the baD state, and by such theorists and the form suggested by such important students of group psychology as Le Bon, Serge Moscovici, Otto Kernberg, and of course Sigmund Freud in some of his more sociological later work. Also key in highlighting and understanding these created psychological processes is certainly Norman Cohn’s account of the millenarian psychological state and illusion and the philosopher Eric Vogelin’s important account of modern day gnosticism.
Without going to the next level of essential detail here since this is just an introductory note let me just point out that the key researchers just mentioned provide, when their accounts are correctly integrated and modified into a new asset approach, a detailed description of the nature and mechanisms of group behavior when the more extreme bubble narrative takes over the group which is invaluable to making important qualitative judgements about the level that the market narrative is playing out in real time as it unfolds in the group. Axiomatically, if there is no sufficient and deeper group psychology account, then there is no real understanding of where the bubble narrative is at any particular point in time, it’s as simple as that.
Premise 3
Traders broadly understood operate in their view in a zero sum game. While not entirely technically true, this starting perspective means that when the narrative is in full swing they will jump on the winning flow side and leverage up that side tremendously overall. If they perceive the potential of the narrative early as it comes to dominate they will even do this sooner in its initial stages depending on their trading style, although this carries much greater risk since many potential dominant narratives regularly in the end fail to capture the market. This trader action to the narrative actually increases the group psychology baD state since it appears to offer confirmation.
This leveraging up in a zero sum game will continue until the capacity of the group to continue this group psychological state starts to be questioned. Extreme baD states always involve to some degree a lack of reality principle.That lack of reality, per se, however is not sufficient for traders to abandon their being on the winning pro-narrative side. The broader market group itself must question the narrative either for internal group psychological reasons of the sort identified by Bion and others or external events force the group to severely question the veracity of the narrative or the weight of trading on the bubble side becomes so high that it becomes itself a prime zero sum target.
Premise 4
Ultimately the Bubble crash involves one of two precipitous causes which will obviously require much greater detail to fully understand. Either as suggested traders abandon the trade and exit or go short the narrative because the broader group itself starts to abandon it or that appears increasingly likely. This is first and foremost a group psychology question not a traditional valuation question. Or because traders simply recognize that so much capital is with the trade and locked up in the asset that the more profitable course is to take that capital and leave or go short and attempt to take that capital. However, in every case the changes in group psychology at bubble tops is not in itself capable of creating a crash unless and until such time as the traders also abandon the narrative. It is this combination of trader action with broader group psychology only which creates the most extreme psychological state of what Bion calls the baF or in this case flight group state. Hence the traders constitute the key transitional object between two distinctive group states the baF and baD. If the trader action leveraged higher the baD group psychology on the way up overdetermining it, on the way down that leveraging overdetermines the baF group psychology. Understanding this group process in which trader action and inner group psychology interact—the two seesaws mentioned earlier, in much greater detail allows the investor to potentially identify where the group and market and asset valuation is at any particular time. While this is a dynamic process and does not lend itself often to simply light switch like judgements, it also means there is little excuse for not having some understanding of the most essential aspects of the stock bubble with potential resulting alpha.
In later notes I will begin to provide a much more detailed account of how each of these key premises plays out in reality and exactly how these elements can be more fully analyzed.
Sources:
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Bion, W. R. (1963). Elements of psycho-analysis. London: Heinemann.
Bion, W. R. (1965). Transformations. London: Heinemann.
Bion, W. R. (1970). Attention and interpretation. London: Tavistock.
Cohn, N. (1957). The pursuit of the millennium: Revolutionary millenarians and mystical anarchists of the Middle Ages. London: Secker & Warburg.
Cohn, N. (1993). Cosmos, chaos and the world to come: The ancient roots of apocalyptic faith. New Haven, CT: Yale University Press.
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