Pavlov’s Market

By Steve Ayer on February 9, 2024

Whether one realizes it or not, all investors around the world have been conditioned over the past 15 + years to expect strong upside in stocks on the back of released stimulus (a treat) after experiencing weakness in the markets and/or the economy. This classical conditioning of investors by the central banks and global governments of the world has been so potent and consistent that I am sure even Ivan Pavlov would be proud of the results. It’s been clockwork over the past 15 years in our markets, which goes something like this:  The economy weakens-we get stimulus, sovereign debt concerns arise-we get stimulus, earnings slow down-we get stimulus, a pandemic hits-we get stimulus…, but then, all of the sudden, inflation appears on the scene and we enter into the worst inflationary cycle of the past 40 years, partly because of all of the stimulus!  What happens after that? Bond prices collapse as interest rates soar because there is no stimulus to hold rates down, which also causes stocks to fall. However, we are now so conditioned to anticipate the next stimulus, that we are already salivating at the prospect of our next treat and that conditioned response has driven up stock prices in anticipation of it.  Markets are a study in human psychology, but this Pavlonian response to the highly unorthodox and experimental stimulus provided to markets over the past 15+ years is really something to behold!

Our primal instinct is to now anticipate and start salivating in advance of the stimulus, just as Pavlov’s dogs did when they were equally conditioned, so we wait for our treat from Chairman Powell (Pavlov), and everything will be ok again. Except…, will it be all good? It’s interesting, but what we’re going to receive is NOT going to look like or taste like what we’ve been used to getting over the past 15 years!

Think about this:

• Lowering interest rates alone WILL NOT provide similar satisfaction to the stimulus treat that we’ve all grown accustomed to over the past several years in the form of QE and other central bank policies from across the world. Many of these more exotic stimulus policies enacted previously actually injected cash directly into the system by holding, or dare I say, manipulating interest rates downward. The only thing that lowering interest rates does is simply to encourage people to borrow more to help stimulate the economy. It doesn’t manipulate rates lower, or fatten up the balance sheet of banks, or put money directly into the hands of investors, it simply encourages companies and individuals to add to their already bloated balance sheets with higher debt, which quite honestly might not be all that attractive for some. So, instead of “chewing on a nice juicy steak” as the treat that we’ve eaten in the past, we’ll now be given a “bucket of oats” instead.

What’s most fascinating about this process is that we, as investors, already know that lowering interest rates alone became ineffective on its own, which is why QE and other more exotic stimulus began in the wake of the financial crises of 2008 in the first place…, because lowering rates was simply NOT ENOUGH.  The reality is that we’re so well-conditioned that our own primal instincts now believe our conditioned response is more reliable than our intellectual knowledge and understanding, which is that the upcoming treats of stimulus will be smaller and probably won’t even make much of a difference in overall economic activity, but it doesn’t matter because our own primal response has overridden our head knowledge.  Of course, the media is contributing to this as well, but more so, it’s our own conditioning that has created this from the Fed’s Pavlonian experiment on us.

• The current inflation data is still a fair distance away from the Fed’s 2% target and most experts agree that getting from where we are today down to 2% or below that level will be the hardest part of this inflation fight. Current market assumptions do not line up with this perspective. This is, of course, a complex issue, but please refer to the Inflation report that I wrote last March, which highlights many of these long-term issues that we’ll have to contend with on the inflation front. One new development since I wrote the paper is the Mideast crises, which was not taking place back then.  I did, however, highlight increased geopolitical risks on the back of the crises in Ukraine war, with war, in general, exacerbating inflation.

This is a topic to dig in to on another day, but think about this:  China, Russia, and Iran have participated in war games together over the past several years, well prior to the Ukraine invasion.  Russia and China have invested billions in Iran and the Houthis, Hezbollah, and Hamas have direct links with Iran. Is it really that far of a stretch to think that there is some level of underlying collusion at work in the geopolitical hotspots in the world right now? What about Venezuela which is now threatening annexation of land at precisely this moment in time? Should it also be surprising that Venezuela’s President expressed his “strong support” for Russia after it invaded Ukraine while the two countries have worked well together in the past? I am not a conspiracy theorist, but connecting the dots here isn’t exactly rocket science and who knows what’s next…, Taiwan, North Korea going beyond saber rattling, or terrorism becoming more wide-spread, or something else?  Why is China selling their holdings in US Treasuries and it’s now sitting at levels that are almost half of what they were at their peak? These types of risks not only increase supply chain risk but can also manifest in many other ways as well.

• Even if we do get down to the 2% Fed target on inflation and we hear the “all clear” message for inflation having been defeated, this will most likely more closely resemble when President Bush gave his infamous “mission accomplished” speech while on the deck of the USS Abraham Lincoln in 2003 about the US’ victory in the Middle East and against terrorism overall.  Unfortunately, most likely we will find our equivalent of finding no weapons of mass destruction – the rise of ISIS, & Hamas’ invasion of Israel and, again, please refer to my Inflation paper that I wrote about last year for what’s possible.

Right now, we’re in the eye of the storm, enjoying the moment that our conditioning has lead us to belief in our next treat, with our primal nature anticipating how good it’s going to taste, so we’re all excited and jazzed up and our mouth is watering for it. This reflects how much the markets have rallied after inflation peaked. Then the 10-year Treasury yields peaked back in late October as everyone began looking for the Fed’s next stimulus. Still, the question from here is what happens when we don’t get the treat that we’re so accustomed to, or even worse, what happens when Chairman Powell (Pavlov) admits that the mission isn’t accomplished, or perhaps even worse than that, is if markets begin to realize on their own that it’s NOT mission accomplished, and reality begins to set in.

Unfortunately, the coming years appear that they will be marked by STAGFLATION, not the goldilocks scenario most currently assume through their conditioning, though in fairness, it does appear that it will take some time before markets begin to understand this, so we could be in the eye of this storm for a while longer. 

What to do? We remain diligent, similar to a red-alert status, for the beginning of the stagflationary mindset to take hold.  We remain steadfast, with flexibility for the implementation of the strategies that can not only protect oneself against these challenges but can provide potentially significant returns as well. 

It’s not all doom and gloom ahead for us. At the end of the day, what lies ahead is just another cycle, and what some may perceive as a depressing and dark forecast, is precisely this same set of circumstances that creates an enormous opportunity for us as well. It’s truly all in the eye of the beholder.