Recognition lags and investing

Mohamed El-Erian in Barron's about the "recognition lag"

Cyclical tailwinds speak directly to the market's playbook. Structural headwinds do not. Then, the market has a problem aggregating all these together into a new picture. Human beings are anchored by certain things.

The minute something takes us out of our comfort zone, out of what is familiar, we need overwhelming evidence that it's happening. That leads to a recognition lag. Market participants are challenged because you can be too early or too late.

We should be out of our comfort zone concerning stocks and currencies. With the stock market and euro in strong down-trends, there is a growing realization that the market could not sustain its recovery if the economy was only growing at 3.2%.

The behavioral bias of anchoring is nicely restated as a recognition lag; however, a recognition lag is more than just having difficulty switching regimes or moving out of a comfort zone. I would argue that there are two parts to a recognition lag. One is finding the right evidence to tell you what regime you are in and second is weighing that evidence to realize there is a change in the environment.

Economic evidence is usually not clear-cut. Data comes out almost everyday with different levels, growth paths, momentum, and revisions. Some data can have a strong change but just is not that important. Other data becomes more important at different times in the business cycle. So there first needs to be a recognition as to what is important overall and what is important at a specific time.

The second part of the recognition lag is determining whether the evidence today is enough to change your view over some future horizon.A perfect example is the first quarter GDP number. It grew at 3.2% which was less than the fourth quarter of 2009. It is as positive but not significant enough if you believe a V-shaped recovery. Now, you can come up with explanations for why this number is less than the last quarter but still believe that a strong recovery will occur, or you can believe that growth will be slower based on the actual evidence presented. So what is more important, the evidence or the context of your current views which may explain away aberrations or noise?

The anchoring problem is when we try and explain away the data to fit our current view. The alternative is that we adjust quickly to the new information only to find that it is noise relative to strong trend. Recognition of being too slow or too fast has problems.