The Nature of Feedback Loops

Feedback loops are everywhere you look in the market. The very nature of the stock market has a lot of self-fulfilling cycles of feedback loops in it. When stocks begin to rally, underinvested longs start to worry about being left out, so they buy. Shorts start to feel squeezed, so they cover. Longs don't want to trim when things are acting well, so they don't sell. Thus, upside momentum is born.

And often, that feedback loop pushes rallies to last longer and go further than most people expect. The stock market bubble of the late 1990s is the most extreme example, when hundreds of now-defunct stocks were trading at double-digit multiples to sales.

In the same vein, when stocks start to fade, the longs want out, so they sell. Shorts become convinced that things are cracking, so they pile on. Underinvested longs become convinced that the selloff is getting legs, so they stand aside waiting for better prices. Thus, downside momentum is born. And you know those selloffs can also go further and last longer than just about anyone ever expects. The crash into October 2002 is the most extreme example, when hundreds of now-very-successful companies were trading at a fraction of the net cash they had on the balance sheets.

These feedback loops and self-fulfilling cycles constantly appear in other markets, too. Today's piece on bond actions from broker MS Howells talked about how the SBC (SBC - commentary - Cramer's Take) takeover of AT&T (T - commentary - Cramer's Take) is likely to cause an inverse reaction to what WorldCom's collapse did in the corporate bond world.

That is, the bond market has reacted very well to the news of the takeover and SBC's bonds have hardly budged since the news broke. The $9 billion in junk debt from AT&T's bonds will likely trade at the much lower spreads of SBC's bonds when SBC completes the acquisition. The gains on those AT&T bonds would then cause a ripple effect in the bond markets because they would likely be reinvested into other junk bonds. That will, in turn, cause junk bond spreads to tighten further, creating more M&A activity. And the feedback loop continues.

Just reverse that entire scenario and you arrive at the negative feedback loop that hit the bond markets in 2002 when WorldCom went caput.

The nature of these cycles is that they last until they don't, and it's next to impossible to guess when they will end. But they are usually multiyear cycles and they usually last longer and go further than any rational mind would think makes sense. As you know I'm fond of saying: It is what it is.

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Cody Willard is a partner in a buy-side firm and a contributor to TheStreet.com's RealMoney. He also produces a premium product for TheStreet.com called The Telecom Connection and is the founder of Teleconomics.com. The firm in which Willard is a partner may, from time to time, have long or short positions in, or buy or sell the securities, or derivatives thereof, of companies mentioned in his columns. At time of publication, the firm in which Willard is a partner had no positions in any of the securities mentioned in this column, although positions can change at any time and without notice. None of the information in this column constitutes, or is intended to constitute, a recommendation by Willard of any particular security or trading strategy or a determination by Willard that any security or trading strategy is suitable for any specific person. Willard appreciates your feedback and invites you to send it to [e-mail].