The normalisation of deviance
It was American sociologist, Diane Vaughan, who first coined the phrase “the normalisation of deviance” to describe a cultural drift in which circumstances classified as “not okay” are slowly reclassified as “okay.” In the case of the tragic Challenger Space Shuttle disaster, the subject of a study by Vaughan, which led her to use this descriptor, damage to the crucial O‑rings had been observed after previous shuttle launches. Each observed instance of damage, she found, was followed by a sequence “in which the technical deviation of the O-rings, from performance predictions, was redefined as an acceptable risk.” Repeated over time, this behaviour became routine, with engineers and managers “developing a definition of the situation that allowed them to carry on as if nothing was wrong.” Put another way, normalisation of deviance describes the condition in which people become accustomed to deviant behaviour, to the point they no longer view it as deviant and cease to see what is clearly visible.
NASA to LTCM to ‘Fed Put’
Prior to the Global Financial Crisis (GFC), whenever policymakers took steps to cushion the adverse consequences of financial distress for a sector – or sectors – of the economy, an outcry about ‘moral hazard’ was voiced by numerous parties, including regulators, politicians, and the media. This is, perhaps, best illustrated by the events surrounding the collapse of the hedge fund run by Long-Term Capital Management (LTCM), in 1998. The strategy underpinning the fund was developed by a team of PhDs from MIT, including a Nobel Prize winner in economics, and executed by a group of renowned Wall Street traders. Investment returns relied on the fund being highly leveraged, to the point it was not unusual for LTCM to have US$30 borrowed for each US$1 of its own capital invested.
After a few years of success, LTCM began to suffer enormous losses and teetered on the brink of insolvency through September 1998, ironically, due to Russia’s debt default that year. It was estimated LTCM may have had as much as US$1 trillion in market exposure through its various derivative trades, at that time. The US authorities had to step in and arrange a bailout, to stave off global financial contagion.
After cutting interest rates, on 29 September, the first scheduled meeting of the Federal Open Market Committee (FOMC) after the LTCM bailout, the Fed Chair – Alan Greenspan – called a special FOMC meeting, on 15 October. At this, Greenspan wanted to cut rates further, but met with resistance from other Committee members, notably Don Poole, who is quoted as asking “Is there any chance theaction today (cutting rates) could be viewed by some as an effort to bail out the hedge funds?”. Despite this, they went ahead, and this was significant as it led to the concept of the ‘Greenspan put’: a belief the Fed would step in with accommodative monetary policy to buoy markets, specifically the US equity market, if prices fall too fast too quickly.
Central banks and the normalisation of deviance
Just 16 months after this surprise rate cut the NASDAQ hit 5000, having risen over 200%, leading to an eye-watering price–earnings ratio of 200x. Trading tech and media stocks became endemic and receiving investment ‘tips’ from your dentist, local shopkeeper or even your taxi driver, became the norm. What once was considered not okay, became okay. The TMT bubble burst – with Pets.com going from IPO to complete liquidation in 268 days. However, arguably the dye had been cast, with the Fed’s action encouraging risk-taking given the expectation central banks will ‘insure’ against excessive market declines, much like a regular put option would do.
Post the bust, each recession has been absorbed by ever-larger fiscal and monetary stimulus packages. Policymaker support through the GFC took this to a new level and was subsequently dwarfed by the financial assistance afforded through the pandemic, at the expense of public finances and ballooning central bank balance sheets. In the interim periods, recessions have been prevented by these loose policies and the disinflationary impact of demographics, disruptive technologies and debt.
Through this era, the most powerful illustration of the normalisation of deviance must be ZIRP – zero interest rate policies – and the onset of negative interest rates. Central bank actions resulted in many societies around the world carrying on as if nothing was wrong when:
- Savers had to pay banks to accept their deposits
- Mortgage borrowers had to pay back less than they had borrowed
- Tax collectors wrote to taxpayers asking them to delay settling their bills
These oddities became accepted, as did the concentration of extraordinary wealth in the hands of very few; huge capital flows into digital assets (particularly currencies that do not meet the definition of money by any standard measure) and levels of inequality which prompted electorates to elect the unelectable. Political leaders that were not okay, have been considered okay.
All of this to boost the wealth effect?
Our collective acceptance of the abnormal for the normal has enabled policymakers to engineer a prolonged and persistent rise in asset prices. Corporates and some households have felt wealthier and spent more. However, in combination with the increased use of leverage and the larger role of the state, the financial economy has grown faster than the real economy, in many countries. This has put pressure on the size of the private sectors that have traditionally provided considerable productivity growth. Capital has been misallocated. Moreover, the ease with which investors have been able to access financial markets – both in terms of trading platforms offering cheaper and cheaper tariffs, and fund management firms offering cheaper and cheaper passive investments – has created a cohort of increasingly wealthy investors who have become ever more complacent.
Implications for portfolios
The quantum physicist, Werner Heisenberg, pointed out that you cannot measure something and observe its movements at the same time; this is because the act of measurement changes the character of the motion. Translating this into the world of investing; the more we believe in the low-risk mantra, the more we explain its features, and the more we think we understand what is going on, the weaker our normal and rational inclination to risk aversion becomes, and the more our actions alter the character of the environment.
We observe that the normalisation of deviance is now the default behaviour for a broad swathe of decision-makers across central banks, governments, regulators, boardrooms and asset managers. Until recently, this year’s torrid market performance was still being viewed through the same deviant lens used for the past 15 years. Add to this mix the relative inexperience of countless sell-side analysts, who are comparatively young and likely never heard of Pets.com, let-alone worked in an inflationary environment. Many – like some managing money – have only-ever operated in an investment landscape where buying the dip has been absolutely the right thing to do; and being long equity beta was a simple to execute and highly rewarding trade.
That time is over.
As per the charts below, today we find ourselves in a much more ‘normal’ economic cycle, with an inflationary environment resulting in rising interest rates, provoking a de-rating in equity multiples. Conversely, a bear market in a deflationary environment (which has been more typical of late) – sees stock prices fall primarily due to slowing growth, leading to earnings contraction. The progress of the decline in equity markets, since early this year, is more reminiscent of the 1973-74 bear market, not the 2000 and 2008 market collapses. Consequently, we expect today’s market correction will run out of gas when interest rates peak or, anticipating success, equities will likely perk up even before the Fed signals a dovish pivot.
We should keep in mind a large amount of monetary tightening is now priced in. This at a time when inflation may have already peaked. It is likely this bear market is actually well advanced. That is not to say we are madly adding risk here, rather we are taking what might be described as an orthodox – think normal – approach, keeping a watchful eye on valuations, financials conditions and the profile of inflation. Rest assured we have our hands firmly on the investment wheel …."Because Pets Can't Drive!"*.
*In January 2000, Pets.com spent $1.2 million on a Super Bowl ad, which introduced the US to the company's answer as to why pet owners should shop online: "Because Pets Can't Drive".
