From Nick Colas, Chief Strategist at Convergex, discussing political impact:
Summary: Delaying gratification in favor of a larger payoff down the road is a prerequisite for success both in and out of the world of investing. One landmark study of the human ability to do so resulted in what is now commonly called the “Marshmallow Test”. Young children are given the choice between consuming one treat immediately, or two after a short wait. Those that can wait, so the theory goes, tend to have better life outcomes. Importantly, one follow-on study showed that the Marshmallow Test is as much a measure of the child’s home environment as any innate ability to control their immediate desires. And that’s where marshmallows and markets truly intersect. Past performance may not be predictive of future results, but it deeply informs current confidence. That brings us neatly to the present day, when after 8 years where the average return on the S&P 500 is 15% investors have a high degree of confidence that equities are still the place to be. As for the next marshmallow? Markets believe it will come from changes in government policy. And we will shortly see if that is true…
A recently published cartoon by The New Yorker caught my eye yesterday. Here is a description:
- President Elect Donald Trump is standing on the steps of the U.S. Capitol building, ready to take the oath of office.
- The Chief Justice of the Supreme Court is holding out a small plate with something on it.
- The caption reads: “You can eat the one marshmallow right now, or, if you wait 15 minutes, I’ll give you two marshmallows and swear you in as President of the United States.”
- If you want to see the actual drawing, it is here:
The marshmallow experiment and Donald Trump…
— Chris Taber (@christaber) January 19, 2017
This being a New Yorker cartoon, there are multiple levels of meaning packed into the humor. When you dump out the psychic suitcase, here is what you get:
- The cartoon is a reference to a late 1960s study of 4 year olds done at Stanford University’s Bing Nursery school. The children were offered a treat (a marshmallow or a cookie or pretzel, their choice). The catch was that if they could avoid eating it for 15 minutes, they would get a second one. The researcher who made the offer then leaves the room, and the child either eats the one treat or waits dutifully until time is up and gets the second one.
- While not originally a longitudinal study (one that follows participants after the research is completed), subsequent work showed that those children who could wait the 15 minutes for treat #2 had materially better life outcomes (grades, jobs, income etc).
- And that’s why this is a New Yorker cartoon – every parent in Gotham (and any other large east or west coast American city) that wants to get their kids into the right kindergarten knows about the Marshmallow Test. Let’s face it – there aren’t that many ways to evaluate 4 year olds. The Marshmallow Test is the SATs of pre-K. Oh, and if you weren’t aware that there are “Right” kindergartens in the world, that’s a whole different conversation.
- So what appears to be just a slam on President Trump is also a sideways glance at the bi-coastal elites that so loath him. They get the joke because they have likely spent hours with their 3 year olds essentially trying to hack the Marshmallow Test.
- If you want to dig into the Marshmallow Test, here is a review from 2010 by the original researcher on the study: https://academic.oup.com/scan/article/6/2/252/1619382/Willpower-over-the-life-span-decomposing-self
- The New Yorker, not surprisingly, has written extensively on the Marshmallow Test as well. Here is a shorter profile of Walter Mischel (the inventor of the test): http://www.newyorker.com/science/maria-konnikova/struggles-psychologist-studying-self-control. And here is a longer form article that goes into more detail (good for parents that still want to help their kids hack the test): http://www.newyorker.com/magazine/2009/05/18/dont-2
All this aside, the most important thing you need to know about the Marshmallow Test is that it doesn’t just test the child; rather, it also measures the child’s household environment and how much trust it creates in these young minds. Research done back in 2011 showed that the test actually measures how much the children being evaluated believe the adults administering the exam. If they seem credible (in the case of this study, delivering on a promise), then the kids involved tend to wait for the second marshmallow. And if they don’t, the children reasonably conclude that a promised second treat may not actually appear. And they gobble up the first one.
You can read a very good (and concise) summary of the work here: http://www.smithsonianmag.com/science-nature/the-marshmallow-test-gets-more-complicated-73835934/
This lesson – that environment drives trust, which in turn enables delayed gratification – is important in understanding capital markets behavior right now. Two points here:
- US equity market returns since an admittedly horrendous 2008 have been remarkably solid. There hasn’t been a down year on a total return basis since then, with S&P 500 returns averaging 15%. Yes, much of the results over the last 3 years have been driven by lower interest rates rather than higher earnings. But they still count – we have consistently gotten our promised second treat.
- That certainly creates a “Trustworthy” backdrop for equity investors to ace the adult version Marshmallow Test, aka investing. Add to that the lack of recent drawdowns – markets have been remarkably well behaved even in the face of Brexit and the Trump win – and you essentially have the ideal environment to foster trust.
- It therefore follows that President Trump’s initial steps in office will have an outsized effect on market action in 2017. He is essentially the researcher in the Marshmallow Test as they first walk into the room. Is he trustworthy? Will he deliver the second marshmallow if we dutifully wait our 15 minutes? Or should we just take the treat of an equity market that has seen a long and profitable run and eat it right away?
In short, the next few weeks matter a lot. US equity markets since the election have traded like the second marshmallow is a pretty sure bet. And it very well may be. But markets will want to see that it exists if they are to wait patiently for it.