Wednesday, November 13, 2019

What Is The "Repo Market" & Why Did The Fed Bail It Out In September 2019?



This post is about the September 2019 bank bailout related to the repo market. It will provide answers to the following questions:

1) what is a repo? 
2) how are banks being bailed out?
3) why is the bailout happening?
4) what does it mean for the great value migration?
5) what can you do?

First, let's understand why the bailout is so important.

Why is the September 2019 bailout so important?

The September 2019 bailout is important because the Federal Reserve is pumping money into OUR economy, non-stop ($260 billion in assets to the Fed’s balance sheet since mid-September). Yet, we have heard little about this. When the Fed bailed out banks in 2008, it was alarming. Everyone knew about it, today, only the business community is covering it.

Why is this bailout happening?

A large bank probably went bust in September. We'll never know which one because it was "bailed out".

How are banks being bailed out?

The Federal Reserve is pumping large amounts of money into the economy every night through an overnight lending program they have set up for banks. For a small fee, banks can make sure they have enough cash to stay open tomorrow. If there's a large demand for overnight funds, the fee goes up. In September, the fee went up so much due to the demand for overnight funds, the Fed had to step in to assist. In other words, the Federal Reserve had to step in to guarantee funding for any bank that needed it.

What is a repo?

A repo is short for repurchase agreement. This is the name of the banking product used to make overnight loans. In the same way that a mortgage is the name of the banking product used to make loans for houses, a repo is the name of the banking product that is used to make overnight loans.

So, when people talk about the Fed bailing out the repo market, they are referring to another massive bailout for the loan market, except this time it's the overnight lending market (repos) not mortgages (mortgaged backed securities).

What is the size of the repo market?

The repo market is huge. According to the Securities Industry and Financial Markets Association, the average daily repo volume in 2018 totaled nearly $2.2 trillion. So the repo market – with about $2.2 trillion outstanding – blew up in mid-September and repo rates spiked to 10%. Then, the Fed stepped in with a bailout.

Why is the Fed allowed to do this?

In 2008, it was decided that certain banks were deemed "too big to fail". As a result, the Fed has the precedent authority to bailout any large bank. So, we'll never know what large bank was bailed out this time (perhaps JP Morgan), but we do know that it took a massive amount of cash to do so. We also know that the Fed is playing this by ear. In fact, they have no idea what's happening. The new Federal Reserve Chair has openly stated his ignorance regarding next steps. This is even more evident in the announcements made by the Fed's trading desk. Brad Huston on Twitter provides a good overview of the Fed's announcements through Twitter below.



High Level Overview

We got in the weeds there so let's pan out for a moment. 

What are the main takeaways from this?

1)  The Fed just bailed out another massive bank (at least one). And, it will continue to do so until the U.S. dollar collapses.

2) The Federal Reserve will do everything it can to prevent a recession. This is a new development in economic theory. It used to be that recessions were an inevitable part of a market economy. Now, they aren't allowed.

What does this mean from an investment perspective?

Ultimately, it means that if you're just listening to MSM, you could be on the wrong side of many trades. It's time to take all the cash you can afford to lose and invest it in the stock market. The Federal Reserve, through its repo program (lender of last resort) and quantitative easing program (buyer of last resort), will continue to support or bailout any issue related to the stock market. The Fed knows the stock market is the primary indicator of economic health for most folks, so it will continue to prop it up by buying assets. This is why the Fed and central banks across the world are pushing rates lower (see article on negative rates below). All that cash has to go somewhere, and it's going into the market. The best thing you can do for your portfolio is buy on dips. 

How does this relate to the Great Value Migration from the dollar to bitcoin?

While it's time to invest your "extra" cash in the stock market (especially the ones that make up the major averages (DJIA, S&P, NASDAQ)), it's also time to start putting the cash that you can't afford to lose in safer places. This means assets that aren't associated or "backed" by a certain institution or counterparty, i.e, real estate, bitcoin, precious metals, artwork, jewelry. That way, if the market fails, it won't impact the intrinsic value of the asset you hold.

What is Counterparty Risk & Why You Don't Want It?

In the financial world, "backing" is referred to as a "counterparty". A counterparty can be a bank, the Federal Reserve or any institution that's willing to "back" an asset. So the risk associated with buying assets that are backed by a certain institution is referred to as counterparty risk. Almost all assets in the market, except for the ones listed above, gain value from the counterparty backing. The dollar is backed by the Federal Reserve. Stocks are backed by the company. Mortgaged backed securities are backed by the people paying the mortgages. Repos are backed by the lender. Bitcoin is backed by the people that use it (no counterparty). Gold is backed by its own intrinsic properties (no counterparty).

The great value migration refers to the migration from currency "backed" by central bankers to currency with no counterparty risk, like bitcoin and gold.

Get ready. We're crossing the Rubicon. 

If you're hungry for more on this subject I recommend:

Max Keiser's video, click here.

To read more about how central banks are becoming insolvent read my article on SeekingAlpha.

To read more about negative rates and what Greenspan, Warren and Cramer think, read my article on negative rates by clicking here.

To read more about the impact of the great migration on the dollar, read my article on the ban of bitcoin and its implication for America.

To read more about the current market phenomena of debt deflation and its impact on the global economy, click here.

Sunday, September 29, 2019

Debt Deflation, Irving Fisher & Why The Fed Should Say "No" To Negative Rates: UBI Is The Only Way To Avoid A Global Depression


World leaders are falling in love with the idea of negative rates to save us from a global recession, but can negative rates save the global economy? 

After much research, the answer is no. If you don't make it past the next paragraph, here's the main thing you need to know about negative rates, they push the stock market up, but do not grow the economy (GDP). As a result, many analysts use stock market growth as a sign that negative rates are good for the economy, when they aren't. The stock market is up because wealth is being forced into the stock market, but there's no growth in the economy. In other words, economies are being pimped by low rates.

In a recent article, I researched what Warren Buffet, Alan Greenspan and Jim Cramer had to say about low and negative rates. There was little agreement. The one thing they all agreed on -- it's not good, and we are in uncharted territory. These same words have been echoed by our past and current Federal Reserve Chairs. 

In some ways, they have a point. We are in a period of unprecedented monetary policy, technological growth, overproduction, Brexit, negative rates and trade tariffs. On the other hand, these times aren't really uncharted. If we drill out for a moment, and look at the situation over a longer period of time, we'll see that we have been down this road before. The causes may seem different, but the end result is the same and it has been well documented, especially by a man named Irving Fisher. He has some lessons to share with us about the ultimate causes of the Great Depression and the answer is universal basic income or as some would call it "helicopter money", not negative rates.

Irving Fisher's Debt Deflation Warning

 

Irving Fisher was born in upstate New York in 1867. He earned the first Ph.D. in economics ever awarded by Yale. Although he damaged his reputation by insisting recovery was imminent throughout the Great Depression, Fisher attempted to answer the same question we are asking today -- what really happened? Or, in our present case, what's really going on? He asked this question in hindsight and so had the benefit of clarity. This clarity told him that excessive debt and deflation are a bad mix. He referred to the phenomena as debt deflation.

Fisher had much time on his hands after losing his family's fortune and finally came to the conclusion that economic policy had conveniently left out one fact -- debt greatly exacerbates economic cycles, especially when mixed with deflation.

Of course, economists know that debt greatly exacerbates economic cycles. We have all been taught that too much cash or liquidity leads to high inflation. So, tools were put in place to prevent inflation throughout the Fed's massive debt monetization scheme (quantitative easing). Inflation become the primary indicator of economic performance.

All eyes were on inflation.

When the Fed saw no increase in inflation, it ramped up quantitative easing even more, which led to overproduction and lower prices. We were all looking for inflation, when we should have been keeping our eye on deflation.

<<As a side note, this article was rejected by SeekingAlpha because they don't think deflation exists. It is the stated goal of central banks all over the world to stop deflation with negative rates, but SeekingAlpha thinks it doesn't exist? They aren't alone. What's going on requires some historical context.>>

How did we get here?

It turns out the initial stimulus back in 2008 created a shock-wave in the market that has only grown in size and amplitude. It is this shock-wave that Fisher attempted to warn us about some 90 years ago. He warned us that debt and deflation amplify the market imbalance. In other words, a regular market can bounce back from a shock. An amplified market can't because each wave grows in strength until something breaks.

Time and regret fueled Fisher's research which produced the paper: The Debt-Deflation Theory of Great Depressions.
The paper consists of 49 conclusions or observations made about the links between excessive debt and economic decline. What makes his theory unique is that it suggests that the economic decline we're currently experiencing is due to deflation, not inflation. Fisher admits that due to the economic theory at the time, he and his colleagues were all looking in the wrong direction, and at the wrong signs (sound familiar?). He then suggests that a new theory be added to explain what occurs when the economy is faced with excessive debt and lower prices.


The Debt Deflation Theory of Great Depressions


Debt deflation is a phenomena in which excessive debt (or cheap debt) creates overproduction, which drives down prices. Lower prices leads to lower earnings, which creates layoffs. Meanwhile, the dollar value of debt is growing due to deflation. In our case, and unlike in Fisher's case, the phenomena is further exacerbated by the pace of technology and automation.

I want to dig a bit deeper into Fisher's most relevant points for today.

First, he felt that there were many causes for market "dis-equilibrium", but only three main "tendencies":
(A) growth or trend tendencies, which are steady; (B) haphazard disturbances, which are unsteady; (C) cyclical tendencies, which are unsteady but steadily repeated.
These are tendencies that can throw off market equilibrium. Fisher then goes on to describe the ubiquitous nature of the market, which is seemingly in equilibrium. This is the same "delicate" market he experienced prior to The Great Depression:
There may be equilibrium which, though stable, is so delicately poised that, after departure from it beyond certain limits, instability ensues, just as, at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks. This simile probably applies when a debtor gets "broke," or when the breaking of many debtors constitutes a "crash," after which there is no coming back to the original equilibrium. To take another simile, such a disaster is somewhat like the "capsizing" of a ship which, under ordinary conditions, is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but, instead, a tendency to depart further from it.
He goes on to say that:
Under such assumptions, and taking account of "economic friction," which is always present, it follows that, unless some outside force intervenes, any "free" oscillations about equilibrium must tend progressively to grow smaller and smaller, just as a rocking chair set in motion tends to stop. That is, while "forced" cycles, such as seasonal, tend to continue unabated in amplitude, ordinary "free" cycles tend to cease, giving way to equilibrium.
So we know that Fisher believed business cycles were natural, but what can his observations tell us about warning signs. Is there anything that would have alerted Fisher that the Great Depression was looming?

To this Fisher would respond,
...I doubt the adequacy of over-production, under-consumption, over-capacity, price-dislocation, maladjustment between agricultural and industrial prices, over-confidence, over-investment, over-saving, over-spending, and the discrepancy between saving and investment.
...each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price-level disturbance.
He refers to these two bad actors as the "price-level disease" and the "debt disease".
While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together,
He goes on to make the point crystal clear:
Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.
...On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33.
Why is this? It's because deflation due to excessive debt has a greater impact than inflation due to excessive debt. This is due to its cyclical and compounding nature. Debt creates deflation and deflation artificially increases debt levels.

In other words, disequilibrium due to market forces tends to create an initial shock to the system that, over time and like a pendulum, will slowly work itself back to equilibrium. Disequilibrium due to market intervention, however, tends to create an initial shock and that shock is just the beginning. When further compounded by excessive debt, its oscillations gain momentum with each swing. This is the impact of debt deflation. It builds upon itself.

In its most heinous form, deflation (or lower prices) actually pushes up the value of the dollar, which only adds to indebtedness. As a result, the debtor is stuck in a loop and can never pay down his debt. Fisher explains it far better than I can in the following paragraph:
...deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing.
He goes on to say:
Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized.
...On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.
In other words, the only way to right the ship is to increase prices.

Reflate The Price Level


The market is full. It has eaten everything in sight for the past 10 years and now it needs a moment to pull back and digest, but glutton has gotten the best of him. The only self-correcting mechanism left for the Federal Reserve is something that relieves bloat.  

In economic terms, the market is asking for a distribution.

It is more commonly known as universal basic income or helicopter money. Presidential candidate Andrew Yang has rebranded it as the Freedom Dividend. You can call it whatever you want, but I like to think of it as a banking and automation distribution. These are the two "bad actors" that got us here and the market is demanding reparations.

Deutsche Bank reportedly said that "helicopter money," a term that refers to giving cash directly to households, "could be highly effective if properly deployed." Some reports claim that the Japanese central bank considered dropping payments to residents, but later decided to approve a $274 billion stimulus package instead.

Most central banks know we're in crisis mode. They know we need to raise prices, but they don't know how to do it. Japan's foray into negative rates in January of 2016 was, in actuality, an attempt to reflate prices, but they failed, over and over again. And now, the Federal Reserve is considering negative rates as well. Thankfully, we not only have the words of Irving Fisher, but our own Federal Reserve Bank of San Francisco to steer us in the right direction.

In August, two Federal Reserve Bank of San Francisco economists wrote a paper assessing Japan’s experiences with negative rates. The paper was titled: Negative Interest Rates and Inflation Expectations in Japan. 

They came to the following conclusion:
Because of the long period of low inflation in Japan, its experience provides an interesting example of the impact of negative monetary policy rates when inflation expectations are well-anchored at very low levels.
...Our results suggest that this movement resulted in decreased, rather than increased, immediate and medium-term expected inflation. This therefore suggests using caution when considering the efficacy of negative rates as expansionary policy tools under well-anchored inflation expectations.
In other words, negative rates don't work. The market loves them because it means free candy from the Fed, but the boat is only tipping over further.

The only thing negative rates are good at producing is higher stock prices, which is why the market rallied on Trump's negative rate tweets. But, does this market approval mean the central bank is acting in the best interest of the economy?

No.

This is the reason Robert Holzmann, the European Central Bank's newest Governing Council member and Austrian central bank governor, went on record as saying the ECB's latest move to lower rates to -.5% was a mistake.


 "Frankly speaking," said Holzmann, "I'm not so sure whether we are playing with the market or if the market's playing with us. Because, if my economics is right, at the moment the market is gaining for getting more and more in the negative territory, so perhaps it wants to lead us to believe that's the way. So, I don't think this market reaction is an indication that this is the way we have to go."
While it may be hard to find agreement on the calculus behind negative rates, everyone does agree on one thing -- quantitative easing and low rates created an unprecedented amount of debt around the world. Now the conundrum for economists worldwide has become: how do we raise prices after quantitative easing? If negative rates don't work, what will raise prices in a world of overproduction and automation?

Some say the answer is trade tariffs, but while trade tariffs raise prices, they also decrease spending. The only answer the market will accept is cash. Not debt, just cash.

This is anathema to the world's power structure, but it is the only answer the market will accept. It is the only answer that has the strength to keep the ship from capsizing.

In normal situations, giving $1,000 a month to every American would lead to inflation. Ironically, many opponents of UBI actually use Fisher’s theory of exchange to support their argument saying that:
...any increase in the supply of money must result in proportional reduction of the purchasing power of money. Since UBI is bound to reduce the economic output by reducing the workforce participation one could expect price-inflation even if the supply of money remained constant, creating another economic hurdle for UBI proponents in the form of net inflation equal or greater to the overall benefit of UBI.
I couldn't agree more, but we are not in a normal situation. Indeed, the impact of UBI (as described above) is the only thing that can get us out of the current debt deflation spiral we're in.  Universal basic income, however much you may not like it, is the only way to reflate prices.

Perhaps this is why Americans from all age groups, backgrounds, political parties and classes are coalescing around Andrew Yang. He is the 2020 Democratic Presidential candidate that wants to give $1,000 to every American. I initially started following Yang when he endorsed blockchain technology, now I'm looking for his policies to save the world from falling into a global depression.

Note: I welcome your feedback below or you can contact me directly via email: celanbryant @gmail.com.

Monday, September 16, 2019

What Do Alan Greenspan, Warren Buffett And Jim Cramer Think About Negative Rates?

Everyone's talking about negative rates, but it's hard to find two people that are willing to say the same thing. In light of this, I thought it might be prudent to see what Alan Greenspan, Warren Buffett and Jim Cramer have to say about negative rates. As on overview,
  • Alan Greenspan thinks negative rates are a sign of an aging population.
  • Warren Buffett thinks that if interest rates are nothing, values can be almost infinite.
  • Jim Cramer thinks negative rates are a sign that we're not in a robust economy (talk about stating the obvious).

Let's start with Alan Greenspan.



Greenspan thinks negative rates are a sign of an aging population.


What's his logic? You can't have negative rates unless you have buyers. Greenspan thinks the buyers represent an aging population that's willing to pay money to secure their cash for the next 20-30 years.

After an awkward start, the host asks Greenspan:
What about the notion of the economy weakening?
Greenspan's response,
It's going to depend in large part on the stock market. We underestimate the wealth effect on the economy...
But then adds,
Overall the economy seems to be sagging.
These feel like conflicting statements, but I digress.

Later, when asked about what negative rates signify, Greenspan had this to say:
What it signifies is that the world population is aging. People are recognizing that they are dying off at a much later date than when they contemplated when they started to save.
He goes on to make a quick comment on gold (XAU):
One of the reasons gold prices are rising so much... that's telling us that people are looking for resources, which they know are going to have a value 20 or 30 years from now as they age. And they want to make sure they have the resources to keep themselves in place. That is clearly the fundamental force that's driving this, but we don't know how far it will go.
This makes sense from an economics perspective, but it assumes negative rates are a common market phenomenon. They aren't.

Warren Buffett disagrees with Greenspan as well.

In an interview on CNBC, Buffett had the following to say about negative rates:
What's happened with interest rates is really extraordinary. You could go back and read everything that Keynes wrote, everything that Adam Smith or Ricardo or Paul Samuelson -- you won't see a word about sustained negative interest rates. I mean we are doing something the world has never seen. It does have the effect of making assets more valuable. Interest rates are like gravity in valuations. If interest rates are nothing, values can be almost infinite.
He goes on to explain what impact negative rates are already having on his company:
So Berkshire Hathaway (#BRK.A) is sitting with billions of dollars of euros in an insurance company in Europe and they will bear a negative rate. We would be better off putting them in a big mattress that we could stick it in -- if I could just find someone that I trust to sleep on the mattress.
If we have a billion euros at minus 35 basis points, it would be $3.5 million euros a year that it's costing us just to have that....It [negative rates] distorts everything...we do not know how this movie plays out.
$3.5 million euro for sitting on a mattress? You can trust me, Buffett. If you're reading this, I've got your back.

He follows up with some Buffett wisdom, spoken like the king of insurance that he is:
In economics the most important thing to remember is that you always want to ask yourself "and then what". After anything that happens, if someone tells you that "this" thing is going to happen, there's always the need to ask "and then what". And then what? In terms of sustained low interest rates the answer is, I don't know.

Jim Cramer does. He thinks thinks negative rates are a sign that we're not in a robust economy.


In response to Trump's negative rate tweets, Cramer had this to say:
I want them to cut rates, but negative rates though, we don't want negative rates. That's just a sign that we're not a robust economy.
To which the host responded:
Is bonehead appropriate for a Fed chief that he appointed?
Cramer:
He appointed him, that was his appointee.
Host:
Yes, it was, well as we all know he tires of people quickly.
Cramer:
Yes.
Host:
In this case though, he can't fire them. Because one would think, given the frequency of Tweets, if he could, it would have happened a long time ago.
Cramer:
David, I think you got a keen eye for the obvious there partner.
Host:
Thank you. Yeah, a keen sense for the obvious is what I've made a career out of.
Cramer:
Yeah, you really have.
Gotta love that Cramer. Let's skip forward a bit to see what he really thinks about negative rates:

Host:
And now you have JPMorgan's Diamond saying they're preparing for zero interest rates. Lowering their guidance on interest income.
Cramer:
Yeah, but I was looking on Twitter and someone also posted that they're looking at 5% yesterday, and it was the best Tweet of the day because it just shows that they're prepared for anything or you could say that they don't know what they're doing.

Takeaways

The truth is, negative rates have been around for a while. Denmark’s policy rates fell below zero in July 2012, followed by the European Central Bank, the Swedish Riksbank, and the Swiss National Bank. Japan set its leading policy rate below zero on January 29, 2016. Now there's over $20 trillion in negative yielding debt in the world (both central banks and corporate). Put another way, banks and corporations around the world are already making money on $20 trillion in debt/cash they issued. It's really a brilliant scheme when you think about it.

What do I think? I think this makes me want to avoid Treasuries and buy bitcoin (BTC), gold and real estate.

That said, negative interest rate policy (NIRP) is a last-ditch attempt to generate spending investment. When combined with more QE, it makes asset prices go through the roof, as Buffett said. At some point, central banks will run out of assets to buy, but if rates do go negative, the market is about to have one last run and that run is going to be explosive.

I think that's the essence of this. If there is ANY one major takeaway from these three views on negative rates, it's that you need to be prepared for anything because what started out as a short-term emergency experiment has become the new norm. And now that new norm has created the need for more short-term emergency experiments because what used to work has stopped. As Buffett would say, we have run out of "and then whats".

Tuesday, September 10, 2019

Herd Behavior In Financial Markets: A Study On Contagion Theory


 "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly and one by one." Charles Mackay (1841)
This is the opening quote in the paper Herd Behavior in Financial Markets by Sushil Bikhchandani and Sunil Sharma published as an International Monetary Fund staff paper in 2001. Marco Cipriani and Antonio Guarino decided to take another look at this paper, published by the Federal Reserve Bank of New York, to see if its conclusions could help to better understand the market in 2015. Likewise, I want to use it to see if it can help to gain a better perspective on the level of volatility in the market today.

Herd Behavior Defined

First, let's define herding. Herding is when a trader disregards their own knowledge or trading plan to follow the behavior of the crowd. The reasons for the Fed's interest in the subject is clear -- to understand how to get ahead of, or put tools in place to counteract, contagion, specifically information contagion as discussed in the article Federal Reserve Bank Of New York: A Study On Contagion Theory.

The authors split the identification of "herding" from the use of data into two categories: spurious and real. Some herding, characterized by clustering in statistical data, may be the result of a public announcement rather than true herd behavior. In response to this the authors present another way to measure herd behavior through a theoretical model.

The Theoretical Herding Model

The model used to test the theory is based on an asset that is traded over a period of time. An event occurs at the beginning of each day the asset is traded. Some traders receive or find public or private information about the asset -- these are considered "informed" investors. All other traders are therefore considered to be uninformed and are therefore considered to be trading due to liquidity or re-balancing. If no event occurs, all traders are uninformed.

So how does this scenario generally play out. In a nutshell, the herd convinces the trader to put its theory over the traders own knowledge about the stock. Here's the thought process:
  1. The informed investor knows something happened to change the fundamental price of the asset.
  2. The investor realizes that their position is the opposite of what's occurring in the market.
  3. The informed investor weighs the importance of their own private information or trading plan against the asset's movement in the market.
  4. If the market movement is deep enough the trader will go against her own plan in favor of the market. The rationale being that the information traders are trading on in the market must be better than what she knows.
In this way, herd trading is a made into a rational decision, at least in our minds.

Example: Ashland's Herd Traders

The authors use Ashland Inc. (NYSE: ASH) in 1995 to further illustrate the theory.
We find that herding on Ashland Inc. occurred quite often: on average, the proportion of herd buyers was 2 percent and that of herd sellers was 4 percent. Additionally, we find that not only did herding occur but also it was at times misdirected (that is, herd buying in a day when the asset's fundamental value declined and herd selling in a day when the asset's fundamental value increased).
The authors go on to find that "the price was 4 percent further away from its fundamental value than it would otherwise have been." This seems like a rather small percentage, but the data supports these findings and according to the VIX, contrary to perception, the market is no more volatile in 2015 than it was in 1995. Based on the chart below, it appears the same can be said for 2019. 



So What

What are the implications of this for the Fed and for the individual investor? The implication is that what we think is volatility due to fundamental changes in the market's value may actually be due to the herd behavior of traders with greater levels of capital to spend. They'll have even more to spend if rates go negative.

That said, it's hard to make definitive conclusions about the application of this data until we have a way to measure a stock's "herd" appeal.
  • Perhaps companies with a higher degree of volume or volatility also have a higher percentage of herd traders. 
  • Perhaps this is the reason stock runs are often followed by corrections. 
  • Perhaps stocks with a high P/E have a higher degree of herd buyers? 
A "Herd Index", theoretically, would be able to provide buy and sell signals that were even more reliable than P/E multiples in finding over- or under-priced stocks. As of this writing I am unaware of any such measure. That said, JPMorgan recently created the “Volfefe Index” to measure the impact of President Trump's tweets on the market so anything is possible.