Confessions Of A Gold Analyst: Everyone Needs A Reason

As supposedly evolved human beings, we fancy ourselves as quite reasonable creatures.  We believe that we are able to rationalize all our decision making.  We are quite proud of our ability to reason through a problem to come to a rational solution.  It all sounds so civilized and reasonable.  Unfortunately, it is not really true, and especially not in the financial markets.

If it were true when it comes to financial markets, then no one would ever buy a company without any earnings.  Think about it.  A company without earnings is only selling “hope,” and hope is not rational . . . it is emotional.  Yes, they may try to rationalize their “hope” with many different types of reasonably supported expectations, but, to be completely honest, at the end of the day, all they are investing in is hope.  And, we certainly know the heights some stocks without any earnings have seen, only to see them come crashing down once the hope dissipates, en masse.  Anyone remember the dot-com era? Was any of this rational?  

You see, most of our decision making is actually not rational.  Humans are hard wired for emotional responses within their basal ganglia and limbic system within their brain, which is a biological response we share with all animals. In fact, in a study performed by Dr. Joseph Ledoux, a psychologist at the Center for Neural Science at NYU, he noted that emotion and the reaction caused by such emotion occur independent and prior to, the ability of the brain to reason.  I would suggest you read that again – “emotion and the reaction caused by such emotion occur independent and prior to, the ability of the brain to reason.”  

Based upon many of the psychological studies I have read, it is quite clear to me that man often, but not always, makes his decisions based upon emotions, and then uses rationale or reason to justify those decisions.  Let me give you an example.    

I was recently listening to Jim Cramer, and he propounded the fundamental perspective that the reason stocks announcing good earnings reports and positive forecast expectations have gone down was because they announced their earnings on a day that oil was going down.  

No one has ever spoken of oil’s effect on this particular company ever before, but since no other explanation was “possible” in the eyes of the investors, they simply looked to the “obvious” seeming correlation in the market: “hey, look, oil was down today, so that MUST be the reason the stock with good earnings and forecasts is down too.”

While maintaining our perspective that we are reasonable creatures, clearly, we had to come up with a reason as to why the stock went in the complete opposite direction it was “supposed” to move.  So, we looked to the market, and came up with the simplest, and seemingly most reasonable, correlation that was available.  

But, let’s be honest with ourselves.  This was not a reasonable decision, but, rather, an emotional one.  And, let’s not try to rationalize something which is emotional.   Have you ever attempted to rationalize with your spouse when they were emotional?   Was that a successful endeavor for you?

I am sorry to say this, but this type of rationalization is intellectually dishonest, and maintaining this type of investment thesis will have you often looking the wrong way and cause unexplainable losses in your account.  

In addition to understanding that most decisions in financial markets are emotionally based, one needs to understand that correlation does not equate to causation.  If one really wants to understand the true cause, one has to look much deeper than a superficial answer, and understand that the answer was not reasonable, but, rather, emotional. Otherwise, one can always find these types of reasons as to why a fundamental perspective is wrong.  Have we not learned our lesson from the gold market for the last 4 years?

I know many are probably sick and tired of hearing me drill this point home over and over, but with so many caught in this false type of market rationalization, I think it is necessary to drill it home ad nauseam.   Ultimately, one needs to be able to track the emotional state of the market, or, as we call it, market sentiment, to gain a much more reliable directional perspective on a stock or index rather than the superficial story.

By Avi Gilburt