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Relief rally hopes

We often feel best not in good times but as bad times become less bad. This raises the possibility of a big rise in share prices soon
November 11, 2020

You probably don’t want to know about Canadians’ colonoscopies. But you should, because they might tell us something useful and optimistic about stock markets.

Back in 1995 Donald Redelmeier and Joel Katz, two Toronto doctors, conducted a series of colonoscopies. At the end of some of the procedures, they left the tip of the colonoscope in the patient. And they found something odd. Patients who had the colonoscope left in them rated the procedure as less unpleasant than those who had it whipped out immediately, even though the procedure lasted longer and entailed slightly more discomfort.

This tells us something about how we evaluate unpleasant experiences. We rate them not by the duration of pain but by what the Nobel laureate Daniel Kahneman has called the peak-end rule. We compare the worst moment to how we felt at the end. If the end is less unpleasant than the worst point, we have fonder memories than we do if the end is also nasty.

Another experiment by Professor Kahneman and colleagues has corroborated this. They got people to put their hand into cold water. For some, they warmed the water up slightly at the end. The latter group reported the experience as less unpleasant than the former group, even though it meant their hand was in cold water for longer. This too is consistent with the peak-end rule: a less unpleasant end causes us to think the experience is more pleasant than we do if the discomfort comes to a sudden end.

This fits with my own experience. I sometimes get attacks of gout (which, I can tell you for certain, are a gazillion times worse than a colonoscopy). As the attacks fade, though, and pain gives way to discomfort, I often feel euphoric – more so than when there’s no pain at all.

What’s all this got to do with equities? Plenty. It tells us that we can feel great in bad times as long as those times aren’t as bad as before. The biggest six-month rise in the All-Share index in the last 30 years occurred between March and September 2009. The economy then was in a terrible state and confidence was fragile. But things were less terrible than they seemed earlier in the year. That was good enough to drive shares up a lot. 'Relief rallies' are real.

Which brings us to a reason for optimism. Sometime soon the pandemic might be under control – either because the lockdown works, or because the test-and-trace scheme is working or (more likely perhaps) a vaccine is introduced. As this happens, the economic damage of the virus will still be with us, in the form of higher unemployment, business failures and fears about its impact on longer-run growth. Nevertheless, the mere fact that things have gone from bad to less bad might be enough to send prices soaring, just as we saw in 2009.

This is especially likely because the peak-end rule might be reinforced by a halo effect, whereby we transfer a favourable opinion in one domain to others. Joy at being able to socialise normally might spill over into a more optimistic attitude to share prices and increased willingness to take risks.

Yes, things seem grim now. But as the old Persian saying goes, “this too shall pass”. And when it does, we could see a huge improvement in our mood and in share prices.