Cutting through the Noise of Volatile Markets
Turbulent markets put behavioral finance center stage. Rational investors typically step back and wait for the disarray to settle, and market efficiency fades. Psychology, however, can be a useful guide. Private clients, their advisers, and institutional investors can all learn from research on behavior. Some surprising incentives and biases come into play in volatile markets.
Market sell-offs attract headlines, making stock markets look important. Sound bites from purported experts fill the airwaves. Though it is understandable to think that all the front page attention, extra column inches, and pundit pronouncements can offer guidance through the crisis, at best, these seem merely to offer a daily dose of fresh narratives that can be relayed to worried clients. These stories may be well-intentioned, but they are fiction.
Exciting new sources of “information” emerge in the form of the perma-bears — the alarmist gurus who can amazingly hold the same position for 20 years, through bull and bear markets. Perma-bears are always telling clients to sell all — that Armageddon is upon us. Most investors, fortunately, ignore this. By the same token, there can be false comfort. Governments and central banks offer superficial and unhelpful reassurances. The entire theater of volatile markets raises the noise level. Amidst all of this, the challenge for investors is to find the true signals.
History points to the value of such a search. Before the financial crisis, key information was being overlooked by most investors and commentators. Some of these indicators pointed to stress in credit markets — particularly in AAA-rated bonds, which should have been safe. Other indicators picked up unusual behavior in lending, housing, and inter-bank finance. In each crisis, some information is effectively submerged. Accessible and ostensibly public, these signals were nevertheless hidden in plain sight.
This submerged wisdom is rarely displayed on the front pages or on our TV screens. But investors must seek it out if they are to find the true source of the panic. It is typically this information that drives any persistent selling, well beyond the point that seems to make sense using readily available public information. When conventional research metrics do not seem to apply, market behavior should not necessarily be dismissed as irrational. The facts may have changed in a way that conventional news sources are missing.
Banks are often good indicators; their leverage exaggerates underlying changes. They also throw out a lot of statistics, from collateral pricing to inter-bank lending and spreads between categories of bonds. When bankers do talk about what is really going on, it is often on blogs, bulletin boards, or specialist websites — that is, in public, but in venues that are easily overlooked. These are not the simple sound bite explanations that get attention.
As markets gyrate, it is too easy to link moves to specific headlines or events, creating an illusion among investors and experts alike that they understand why things are happening. If we are told the cause is China, and that seems to make sense, we are less inclined to look for a deeper explanation. But deep problems rarely bounce around in synchrony with share prices. The information that drives stocks into oversold territory, way below their longer-term moving averages, often accumulates steadily and persistently. Superficial correlations can mislead.
Studies of human and animal behavior show that responses change in turbulent environments. Information gathering that is normally reliable suddenly becomes less useful. For example, investment teams structured to value banks on traditional metrics were blindsided in 2008. Assets and dividends evaporated.
In changing conditions, it becomes even more important to recognize that new signals matter and that these must be captured in different ways. Looking externally at what others are doing becomes worthwhile. This need not be blind herding; it may be an innate response that is likely to have some historical survival value.
Long-established investing institutions, usually confident in their methods, can find it harder to broaden their inputs and change tactics. Process wins accounts and reassures clients. As a result, any change in information gathering or use of new metrics must be carefully implemented, with client support. That takes time and reduces agility in times of rapid change.
Looking at what others are doing as opposed to what they are saying, and searching more actively for any wisdom that drives such behavior, is a good strategy. Find what the proven smart money is doing. It might not lead to joining others in a selling panic, but rather to recognizing where safety lies and which sectors to hold.
In market turmoil, fundamental equity investors could look harder at credit, currency, politics, and liquidity. Buying on dips can too easily reflect the gambler’s fallacy of overconfidence in long-term averages. Consider how long the commodities’ super-cycle ran, driving an over-representation in many indices and a misplaced confidence in earnings. Bubbles happen when the ridiculous is accepted as normal, and when what is normal becomes a poor guide for portfolio re-balancing and risk. Attaching undue weight to the most prominent and recent information gives the headlines too much respect.
Changing conditions impair the signal-to-noise ratio. Investors should commit more time to looking for deeper explanations for market behavior. Tempting as it is to follow the media’s daily focus on China, investors should look more closely at stress in corporate bond funds, emerging economy politics, and currency moves.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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