If you couldn’t already tell I’ve been thinking about cognitive biases and logical fallacies a lot lately. And while I’ve been fairly bearish for quite some time now I haven’t been, “sell everything and hide your cash in the mattress bearish.” Those who are that bearish are suffering from clear biases or fallacies I’ll get to in a minute. By the same token, those who are rip-snorting bullish right now are also suffering from a similar condition.

By being overly bullish right now, you’re simply in denial over a plethora of evidence that suggests the risk/reward equation is heavily skewed toward the risk side without much potential for reward at all. But what I really think bulls are relying on most heavily right now is a little something called “recency bias” or, as the Fed likes to put it (emphasis mine):

If asset prices start to rise, the success of some investors attracts public attention that fuels the spread of enthusiasm for the market. New (often less sophisticated) investors enter the market and bid up prices. This “irrational exuberance” heightens expectations of further price increases, as investors extrapolate recent price action far into the future. – “Asset Price Bubbles” FRBSF

That’s all “recency bias” is: investors ‘extrapolating recent price action far into the future.’ In other words, Mr. Market has been flipping a coin that just keeps coming up heads (big gains) so investors begin to believe that it’s just going to be heads forever. Tails (corrections or bear markets) are a thing of the past.

Obviously, this is just faulty logic. But when BTFD becomes so ingrained into the broader market psyche it just becomes painfully clear that investors are relying on nothing but the trend. Which is fine, of course, until the trend comes to an end. Just don’t pretend there are any other reasons to be bullish aside from the trend because there just aren’t.

On the flipside, uber-bears are suffering from a similar ailment called “gambler’s fallacy.” They believe that because Mr. Market has flipped heads so many times in a row (how long have we gone without a 10% correction?) that the likelihood of him flipping tails is now much greater which is also bogus logic but something people do all the time. The likelihood of flipping heads or tails is still 50% no matter what sort of streak has come before this flip of the coin.

Despite the fact that the odds haven’t changed at all, bulls believe there’s a near 100% chance the next flip is gonna be heads once again (because it’s just persisted so long) and bears believe there’s a near 100% chance it will be tails (because the ridiculous streak of heads just can’t persist). Both are wrong. So what’s an investor to do?

To me the fundamentals, sentiment and the macro backdrop are clearly bearish right now. But I grant that these are not timing mechanisms. These are just the shade of the lens we should be looking through right now. In 2009, you wanted rose-colored glasses because all three of these indicators were flipped. Today, you want the opposite, whatever that is (brown-colored glasses?).

Still, you probably don’t want to express that view in your investments to any great degree simply because Mr. Market is still, in fact, flipping heads… for now. So don’t get me wrong; I’m bearish. Clearly. But I’d recommend waiting until Mr. Market flips a tails or two to before jumping feet first into your bear costume.

Next week I’ll post the third in my “market timing” series which will make this much more clear.

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