Market insights and analysis

By Jerry Wagner

Since Veterans Day is this Saturday, I would like to take a moment to express my gratitude to our veteran readers. Thank you for your service! Without your efforts, we would not have the free economy and financial markets upon which I can comment and from which my readers can prosper. Again, thank you.

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I used to refer to “the elephant in the room” when discussing a significant issue that most investors seemed to overlook. However, my phrasing changed around 2000 when an enlightening study, building on previous research by Ulric Neisser and Robert Becklen from 1975, was completed at Harvard. This research has since been called the “Invisible Gorilla” study. The study’s findings and implications, reported by Professors Daniel Simons and Christopher Chabris, were the basis of their 2010 book by the same name.

In the study, researchers asked students to watch a video in which six players, three dressed in white and three in black, tossed around a basketball. They further told them to count the number of passes made by the team dressed in white. Most correctly counted the number as 15.

At that juncture, the viewers were asked, “Did you see anything unusual in the video?” Half of the viewers indicated they had not.

Then they were asked, “What about the gorilla? A man dressed in a gorilla costume walked into the video, stood in the center of the players, beat its chest three times, and then walked out of the scene. You didn’t see it?” Over 90% of the viewers said they would have seen a gorilla, but only 50% did.

In an excellent and entertaining video, Professor Simons, with the help of his “400-pound gorilla,” describes the study’s conclusions. He notes, “The mismatch between what we see and what we think we see has all sorts of profound consequences in our daily lives.”

This inattentive or, as the professors term it, intuitive watching is rampant in the world of investing. We consume a vast amount of information, yet our minds recall just a fraction of it. Then, based on that small slice of retained data, we are expected to make investment decisions in the here and now.

Of course, this in and of itself is exceedingly difficult for the human mind to handle (which is why Flexible Plan Investments, FPI, relies exclusively on quantitative management drawn from our computers to inform our investment research and decision-making). But to make matters worse, our attention is often directed toward and focused on the wrong actions.

Financial headlines appear daily in the papers. Business stories or economic reports are often one of the lead stories on the radio or the internet reporting throughout the day. TV reporters tell us the narratives they think are interesting—or, more often, the most controversial. We take it all in. Like the participants in the study, our brains draw us to all of the movements of the basketball players and to follow the instructions to count the number of passes … but can we see the gorilla in the room?

Can you see the gorilla in the room right now?

As I explained in my most recent article, without the benefit of hindsight, no one can say with certainty what’s happening in the market. But from my chair, the invisible gorilla this time around is the resumption of the stock market rally that began last October in the depths of the 2022 market correction.

We’ve had plenty of movement. But instead of basketball passes, our attention has been drawn to rising interest rates from a hawkish Federal Reserve, the horrific loss of innocent life in the Middle East, and three straight months of losses in the major market indexes.

Yet there it is—the gorilla walking through the room. And it's right where we would expect it to be if we could focus. Where else would we expect a rally to resume if not in the pit of a decline?

Why can’t we focus?

Well, first of all, we are all still hurting. As stock investors, we saw a sudden decline of over 30% in stocks in 2020. We recovered quickly, but almost as quickly, the beginning of 2022 brought us another 30% decline—and this time, both stock and bond investors felt the pain.

Secondly, there have been all those news stories. Earnings reports have been good, but will they continue to be? And why aren’t stock prices reacting positively to the repeated beats of the analyst projections?

We received an exceptional third-quarter GDP report, and the economy is surging. However, many economists keep telling us we are on the edge of a looming recession.

We go to the bank, and the signs heralding a new epoch of high-interest rates are everywhere. Turn on the TV or browse the internet, and the images flood you with ads for high-rate fixed-term annuities. “Tie your money up these vehicles while rates are high,” they scream. Yet our recent research shows the huge opportunity cost of such actions.

It feels like we are being intentionally misdirected, like trying to spot the pea under one of the three cups in a huckster’s game in Times Square. “It’s over here. No, it’s there. Which cup is it under? It’s not there. It’s over here.” It’s easy to feel that you just can’t win.

Spotting the “gorilla” among market movements

Last week, we had the best weekly performance of the major stock market indexes in 2023. Stocks and bonds both rose in price.

While I was getting my first degree at Michigan State University, a brilliant finance major from the Wharton School began and ultimately completed his Ph.D. in finance. Marty Zweig became one of the top hedge fund investors ever. He left us with several books filled with market wisdom. He also developed an indicator known as bullish breadth thrust, which continues to have an excellent track record for calling the direction of the stock market. Last week’s market action shifted that indicator into the bullish column.

In 1969 (the same year Marty received his Ph.D.), Sherman and Marian McClellan developed the McClellan Oscillator, used by market technicians ever since. After their passing, their son Tom carried it on. This tool also generated a significant buy signal with last week's market action. This particular signal has fired 32 times since 1978 without a loss. Moreover, it has an 87% success rate since 1962.

The Market Environmental Index used in our Market Leaders strategies also registered a buy signal. But it was an exceptional buy signal this time around. The measure jumped more than 10% in a single week. This size of move has only happened eight times since the 1980s, and every time, the S&P was up 12 months later and delivered double-digit returns.

As I wrote in last week’s Market Update, we’re now in the most favorable seasonality period of the year. Historically, the November and December period is the most favorable two-month period for stock market returns. Furthermore, in years when the market is already up and in years preceding a presidential election, the likelihood of a positive year-end is even higher.

Our Classic strategy has a renewed buy signal, the QFC Political Seasonality Index strategy is back into stocks, and the QFC Self-Adjusting Trend Following strategy remains fully invested. Also, our Systematic Advantage strategy just signaled an all-clear.

The gorilla is walking through the room. Do you see it?

Dynamic risk management offers the flexibility to adapt

But what if these positive indications prove to be an illusion—just another distraction? What if they are wrong this time? What if it's not a gorilla in the room but merely two basketball teams passing the ball?

That's the beauty of using an investment manager employing a dynamically risk-managed approach, as FPI does. Unlike those that hold CD and fixed-term annuities, we are not locked into our investments. We can move to the sidelines. We can use our many defensive vehicles, which were designed to mitigate losses.

And most importantly, by using many strategies in the same portfolio, we can always hedge our bets. For example, our very short-term QFC S&P Pattern Recognition strategy moved to a temporary short position at the end of last week, and our Volatility Adjusted NASDAQ strategy cut its equity exposure.

“Looking isn’t the same as seeing,” said Daniel Simons in describing his research.

Are we inattentive observers, following our intuition instead of seeing the big picture? Are we missing the 400-pound gorilla in the room?