Benson's Economic & Market Trends
The Fed and Pavlov's Sheep

Richard Benson
May 21, 2004

Ivan Petrovich Pavlov was a brilliant Russian Physiologist whose experiments on animals led to discoveries that would make the demented doctors in World War II, in both Germany and Japan, very jealous. Some of Pavlov's early work was done on sheep. Unfortunately for the sheep, they tended to first crap out and then die of heart attacks. Pavlov's work on sheep, analogous to retail stock investing, is critical for this article because retail stock investors do tend to act a lot like sheep.

(Pavlov's best known work was done on the conditioning of dogs which, in one-on-one sessions, more closely tracked the behavior of people. Sadly, for the plight of man, his research was quite successful and has been the basis for additional research in interrogation techniques. These proven techniques use "Cruel and Usual" physical and psychological torment. This has been quite painful for Capitalists under Stalin, Communists in Latin America during Richard Nixon's term, and any "intelligence prisoner" anywhere, as evidenced by recent photographs from Iraq. Indeed, human experience speaks to the wisdom of the United States Constitution in banning "Cruel and Unusual Punishment.")

Pavlov's work on the conditioned reflex reaction of sheep to stimuli should be of the utmost importance to the Federal Reserve at this juncture in a clearly over-valued stock and bond market.

In Pavlov's research, he discovered that if he gave the sheep a mild electric shock, it would bother them very little and their life would go on pretty much as if nothing had happened, as long as the shocks were random. Warning the sheep in advance of a shock by ringing a bell, however, affected their behavior and it changed radically. The sheep were just smart enough to know that if they heard the bell, the shock was coming. After repeating this exercise a few times, the poor sheep crapped all over the place; after a few more warning bells, the sheep started dying of heart attacks.

What is unfortunate for the Fed and what any old stock market pro knows - and what Alan Greenspan should absolutely know - is that mass retail stock investors act just like sheep. Indeed, for the major market participants, retail investors are there to get "sheared at market tops." Somebody has to buy when the smart money wants to sell. Moreover, to keep the herd of retail investing sheep grazing on financial investments, there has to be a steady stream of "feel good" press. Therefore, the market is always fed happy stories by the Federal Reserve Governors, the Secretary of the Treasury, and, of course, stock analysts, telling the sheep all kinds of "horse hockey" that everything is all right with the markets and there has never been a better time to invest!

So, what has the Fed done? In a relatively short period of time, they went from saying "considerable period" to "patient" to "measured." They haven't even given the investing sheep the first 0.25% mild shock. By ringing the little bell twice, the Fed got the 10-year note to sell off 7 points; NASDAQ to sell off 12%; the Dollar to strengthen 10%; gold, silver, and emerging market debt to "cave in;" and, every carry trader and hedge fund in the reflation trade to cower in a corner, whimpering in fear, that the Fed will start ringing more bells and actually begin administering mild interest rate shocks. Worse yet, the market participants that have been running like lemmings for the edge of the cliff are the market professionals!

What will the behavior be of the retail investing sheep as the Fed moves forward and starts to set the following regular pattern: Ring a Bell; Raise the Funds Rate; Ring a Bell; Raise the Funds Rate. A neutral Fed Funds rate is 3% to 4%, so there are a lot of little shocks yet to come.

We would recommend that the Fed have tranquilizers, soma, and lots of liquidity ready to bail out the markets as they get ready to start scaring the sheep. P/E market valuations for stocks and inflation rates, compared to bond yields, suggest that scaring sheep should be easy. Retail stock and bond investors can follow the lemmings over the cliff at any time (you should watch money flows into stock and bond mutual funds very closely).

Because the Federal Reserve and Treasury have regular practice "fire drills" on what to do during a market crash, and given their behavior and what Pavlov taught us about sheep, they will more than likely create an opportunity to fight a real financial market fire.

Richard Benson

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