The Hedonic Treadmill And Wall Street

“Happy thou art not; For what thou hast not, still thou striv’st to get,
And what thou hast, forget’st” Shakespeare, Measure for Measure

The hedonic treadmill is a theory developed by psychologists in the 1970s. Basically it says that as we increase our material wealth and become more successful, we only ever see a temporary boost to our happiness levels.   We buy a nicer car, we move to a better neighborhood and we buy a bigger house. However we soon adapt to these new conditions and the initial happiness/ excitement we felt returns to the baseline level of before. Or, described in the language of psychology:

“Neurochemical processes desensitize overstimulated hedonic pathways in the brain, which prevents persistently high levels of positive feelings”

This feeling will be familiar to seasoned investors in the stock market. The first time a company surprises on the upside, Wall Street loves it. CNBC proclaims “they sure knocked that one out the park” and the stock rises 20%. Then the company beats expectations a second time and the market cheers again (it’s a smaller cheer but the stock is still up 10% on the day). The company goes on to beat multiple times and the stock continues to rise steadily (though the hit is never quite so big again). It gets a reputation for beating every quarter. Everyone loves it and everyone wants to own a piece of it. If you don’t own it in your portfolio, clients want to know why not. Sell side brokers start to make dumb comments like “it’s the only game in town” This can go on for many quarters, even years, with the stock staying in favor, and continuing to rise. But the longer this goes on, the more the company needs to beat in order to keep rising. One day the company only beats earnings by 5% and the stock doesn’t move. Less experienced investors scratch their head and wonder what’s going on.

Then comes the day when the stock is no longer beating expectations, or it even misses numbers. The market vomits. The miss doesn’t even need to be a big miss – maybe only 2-3%, but the stock plummets. The investors who bought into the excitement suddenly wonder why they hold it and immediately exit their entire position.  Future earnings expectations are pulled down drastically, while the P/E multiple applied to those earnings falls in tandem. Again, the less experienced investors look on in confusion. They don’t understand how the company just lost $5 billion of value because of a 2-3% miss.

This is equivalent to the guy with a nice house in a nice neighborhood suddenly having to take a pay cut. He’s still earning way more than he was when he was 22, but relative to his current expectations and his lifestyle, he’s devastated.

Phil Fisher, the legendary growth investor, was very familiar with this situation.  He was a seasoned investor in growth stocks and he was acutely aware of what happens when growth expectations get ahead of themselves

“…we come to what is by far the most dangerous group of all: companies with a present financial-community appraisal or image far above what is currently justified by the immediate situation. Purchase of such shares can cause the sickening losses that tend to drive investors away from stock ownership in droves and threaten to shake the investment industry to its foundations” Phil Fisher, Common Stocks and Uncommon Profits

This is why it’s important for investors to know what market expectations are. It provides us with a clue as to the mentality of the market and how fast investors are running on the “hedonic treadmill”. The faster it’s going the more dangerous it will be to get on – it may look exciting but at some point you’re going to come off and it’s going to be painful.

“This point cannot be overstressed: The conservative investor must be aware of the nature of the current financial-community appraisal of any industry in which he is interested. He should constantly be probing to see whether that appraisal is significantly more or less favorable than the fundamentals warrant." Phil Fisher, Common Stocks and Uncommon Profits