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Confidence Crisis - Part 1

• Socionomics is the study of the relationship between mood and decision-making. Lows in mood, or confidence, can bring about highly emotional and impulsive behavior in markets, politics and culture. 

• The confidence of consumers and businesses by many measures today are at crisis-like lows. Extremes in confidence can become self-reflexive, where waves in sentiment begin to affect fundamentals directly, thereby reinforcing the previous waves in sentiment.

• In times of extreme under confidence and regime change, the need for forward-looking views and active management in modern portfolios is greater than ever.

Economics or Socionomics?

The traditional presumption is that social mood is governed by economic, political and cultural trends and events. Socionomics hypothesizes the opposite – that the social mood is what determines the character of social action, including markets, politics and culture.

A concrete example of the traditional versus social causality is as follows: “A recession causes business leaders to become cautious” (traditional) versus “Cautious business leaders cause a recession” (socionomic). Both schools of thought may be accurate to different degrees at different times, but the uncertainty around the economy and monetary policy today has the social mood at an extreme.

Consumer & Business Confidence Are Very Low

Two of the most-followed indicators for US consumer confidence are the University of Michigan Expectations Index and the Conference Board Consumer Confidence Expectations Index.

The University of Michigan index surveys 600 households and focuses on three areas: how consumers view prospects for their own financial situation, how they view prospects for the general economy over the near term and their view of prospects for the economy over the long term. The Conference Board index surveys 3,000 households and asks consumers about short-term business conditions, their labor market outlook, and financial prospects six months ahead. These indices are currently in the 1st and 7th percentiles of their history, respectively.

20220712-chart-1The driver of this consumer sentiment is at least partly inflation-related. As shown in the chart below, the University of Michigan subindices for buying conditions of household durables, vehicles and houses are all in the 1st percentile of their history, with data collection going back to 1978.

20220712-chart-2In addition, a Gallup poll conducted in June demonstrated another record low in Americans’ confidence across all institutions1. This year’s 27% average of US adults expressing “a great deal” or “quite a lot” of confidence in 14 American institutions is three points below the prior low from 2014, and 9 points below the reading in 2020.

Finally, the manufacturing sector is now at extremes in under confidence as the average of Federal Reserve Regional Banks’ New Orders 6 Months Ahead indices’ is currently on the lows of the Great Financial Crisis and the onset of the COVID-19 pandemic.

20220712-chart-3Extremes in Confidence Can Create Reflexivity

In George Soros’ Alchemy of Finance he writes on the topic of reflexivity theory in economics, which states that investors don’t base their decisions on reality but rather their perceptions of reality. The actions that result from these perceptions have an impact on reality, or fundamentals, which in turn affect investors’ perceptions and thus prices. The process is self-reinforcing and tends toward disequilibrium, causing prices to become increasingly detached from fundamentals. He states: “[market prices] do not merely reflect so-called fundamentals; they themselves become one of the fundamentals which shape the evolution of prices. This recursive relationship renders the evolution of prices indeterminate and the so-called equilibrium price irrelevant.”2

In times of confidence extremes, markets are in disequilibrium and price becomes the news. Whether it was negative interest rates related to the overconfidence of policy makers believing they can run governments with infinite money supply, or a multi-trillion dollar market capitalization in cryptocurrencies and related protocols from the blind and eager followership of fantastical promotion, or the rare simultaneous drawdown in stocks and bonds from the accumulating under confidence we’ve observed in 2022, reflexivity is in action.

Reflexive Regimes Demand Active Management

When markets are in disequilibrium, models and portfolios constructed solely upon historical data begin to suffer. This environment demands a more nimble and sophisticated approach that explicitly incorporates the forward-looking views of the investor subject to the confidence, or estimation error, around his or her views. Active management, which has been pushed to the wayside by the passive market capitalization-based model of portfolio management, suddenly has an opportunity to add significant value.

In a follow-up Part Two to this Two Minute Tuesday, we will dive deeper into confidence with respect to its role in building portfolios.

Important Disclosures & Definitions

1 GALLUP, as of 07/05/2022

2 Soros, George. The Alchemy of Finance. New York. John Wiley & Sons, Inc. 1987.

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

One may not invest directly in an index.

AAI000182 08/31/2023

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