What not to wear

I mentioned on Monday that I’d read a book called ‘Mistakes were made, but not by us’. As books on the human condition go, this comes out of the top draw.

The central idea is that we all invest ourselves in our views. Of what kind of people we are. What kind of people yous are, the right way for society to treat its rich and its poor. Whether the US is debasing its currency and gold is heading for $2000/lb. Or whether the implosion of the banking system is to send us into debt deflation and Dow 2000.

When we get invested in a view, it becomes part of us. I’m a caring person – because I say that society should subsidise its poor. I’m a libertarian and a realist, because I say that society should allow extreme wealth, because that creates the opportunity and motivation for people to better themselves. And so on. When you have an internally consistent global macro view, it’s very easy to start thinking you’re smarter than the average bear.

And then something happens that doesn’t agree with your call – it creates a dissonance. Not just with your view, but with your view of yourself.

So it’s natural, it’s a self-esteem survival instinct, to diminish in your mind data that undermines your view and you with it. And to accentuate the positive – to bolster your own standing.

Now this is all very well, you might say, and I can see that people do this, but it doesn’t happen to me. That is one of the clever things in the book – that’s exactly what you would say, in spite of evidence to the contrary, to preserve your self esteem. And damn it if I don’t see myself do it, and the people around me do it, every single day.

Now, in my view, it’s just this resistance to mental change that causes the building feedback loop of price change, P&L and popularity that is at the heart of boom & bust.

It’s one reason I’ve got some sympathy with Robert Prechter’s theory of socionomics – that it is changes in social moods that govern markets, that then feed back to economies, and then to broader social developments (like the rulers we choose, and their tendency to start wars).

Now one implication of Prechter’s view is that social moods move in waves - it’s the most efficient way for a natural process to organise itself. Woody Dorsey, who wrote ‘Behavioural Trading’, also talks about the lifecycle of themes, and he carries out surveys to find out how prevalent, or out of favour, themes have got.

So the situation up to last week – with financials going asymptotic down(ie the trend accelerating) and oil going asymptotic up – well that got the bahaviouralists to fever pitch. Both themes have been trending for the last 18 months, and accelerating for the past year. On the one side, oil was running out – and the oil price was heading for $200/bbl. On the other, the financials were heading for zero. But it’s dangerous to extrapolate these themes – because ultimately, I think, they become mutually exclusive.

And the behaviouralists would say that both themes have gone so far, and become so widely accepted, that the natural move now is for oil to fall and financials to rise.

That brings me back to my point about dissonance. A lot of people are heavily invested, personally and professionally, in the ideas of a falling dollar, rising oil & gold, and falling financials.

But I think that there is a big dissonance out there – and that is the shrinking US current account deficit, the shrinking banking multiplier, the rising cost of capital and the falling returns in the developing economies.

That kind of stuff can loosen bottlenecks pretty fast. It can also generate extreme credit stress in poorly managed peripheral economies.

So my call here is that we move forward in waves of disinflation and deflation. When oil starts to fall, and markets are oversold, it’s right to buy disinflation; US autos, global airlines, Western and Asian consumer stocks, even bombed out financials.

Then, when markets have bounced, it’s right to bet on the next wave of debt deflation – this time in Europe, especially Eastern Europe.

And through the whole thing, if I’m right, it’s right to be long the dollar, and short commodities. So far, the call is working nicely, and I’ve just hit a new high of 41% up for the year.

In my next piece ‘Perfect Swing’ I’ll talk about some unusual aspects of the current market action – that has caused a surprising (at least to me) spike in volatility in my fund – and what I’m doing to control my risk.