02 Apr Markets don’t fall just because the news is badRead Time: 4 minutes
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After commenting last time on the propensity of humans (and thus stockmarkets, whose movements are ultimately driven by human behaviours) to be more influenced by bad news than good, it is worth considering why markets can still fall even if there is no obviously bad news that day.
Corrections – a fall of at least 10% – are very common in stockmarkets and they happen in most years. Presumably this is why the MIFID II regulations which require discretionary managers to notify clients of falls in their portfolio only apply to falls larger than this. Most investors will be aware after not very long in the market that such things happen frequently and therefore need not be the focus of their concern. Initially therefore, such fluctuations are often reversed fairly quickly.
However, once falls exceed this, some (up to around a third) will begin to feel uncomfortable. Some of those will decide that they just cannot live with the falls and they decide to sell. As we know, market prices are a function the balance between buyers and sellers and if there are more of the latter, that tends to apply downward pressure to them.
Also contributing to pushing prices down are investors who originally bought on margin, so when prices fall, they either need to stump up more cash or sell to close out their positions. If they don’t have the additional cash, further downward pressure on prices is the result. This then triggers more panic from investors once the falls hit their personal tolerance for losses, then more margin calls and so on.
Some investors operate using trading strategies which aim to exploit momentum (the tendency of prices to follow a trend, until they stop doing so) so once the trend changes from up to down, they start selling their long positions and buying short ones. This creates further downward pressure which leads to the same cycle of responses from other investors.
There are also funds which target a particular degree of risk. These measure risk by volatility (despite this being a manifestation of risk rather than the actual risk) and use that to determine their asset exposure rather than the traditional approach of starting with the asset exposure and accepting the resultant volatility. When markets are relatively calm, a diversified portfolio has low volatility so the fund can aim for a higher volatility (by gearing) and adjust its allocation accordingly. Once the direction changes however, investors start to focus on a single source of risk, volatility rises and correlations between assets increase, so the portfolio now looks rather less diversified than it did previously. Maintenance of the fund’s target risk now requires disposing of assets, which will be into a falling market. While such funds are not common in the UK, the Wall Street Journal recently estimated that they account for US$175bn of assets. When their activities are added to that of other sellers, it pushes prices down more.
Then there are structured products. These are the by-product of a financial institution wanting a particular exposure to the market for some purpose that it has determined. However, the institution needs a counterparty on the other side of the transaction and the retail versions of these, I was told years go by a chap who designed them, are basically that other side. That would be the side that the institution didn’t want. I wonder why that would be…. When markets have fallen, these sell like multi-packs of toilet roll in a global pandemic to investors who are easily persuaded that they can have the (positive) returns from equity markets but without the (negative) risk. An example might provide the return of a market index such as the US S&P500 or a UK index of 100 large companies up to a cap of say 10% in a year but with a maximum fall of 10% in a year. When the index moves within that range, all is fine for the issuer. Once it falls more than 10% though, the issuer needs to hedge its exposure by selling futures in the index, pushing prices lower. By now you will have worked out what impact that has on other investors.
The result of all this is that markets tend to overreact to bad news in much the same way as they overreact to good on the way up (remember US Federal Reserve Bank Chairman Alan Greenspan’s famous term ‘irrational exuberance’ during the dot com boom of the 1990s?).
Unfortunately, as US research house Dalbar’s studies repeatedly show, investors are, on average, terrible at managing their reactions to this. Its 2018 ‘Quantitative Analysis of Investor Behavior’ study showed that in 2018, US investors lagged the market in both good months and bad ones, decreasing their equity exposure too late and then missing the recovery by still being in cash. The outcome was that in a year when the US market as measured by the S&P 500 index fell 4.38%, the average investor managed to lose more than twice as much. These findings are consistent with previous Dalbar studies going back to 1994. Unfortunately there is no reason to assume that US investors are uniquely bad at this compared to those elsewhere in the world.
We have never claimed to be able to predict when markets will change direction or for how long they will move in whichever one they are currently. Instead, a consistent and disciplined rebalancing process forces the sale of assets which have performed relatively well and the purchase of those which have not so as to maintain the portfolio composition which we have agreed with each client is appropriate for their circumstances and goals. It has been tested several times now, most recently in the March 2020 fall, and meant that our clients ended up buying at what has so far been pretty close to the lowest point in equity prices. We have no idea whether there will be further falls but at some point there will be a recovery. History suggests that it is often sudden and that people who try to spot it will miss it while they await more certainty.
The future is never certain. Anyone who claims to be sure of it is best ignored – in my experience there is a correlation between how smart someone is and how little they claim to know and the more certain someone is, the less reliable their forecast is likely to be. Relying on any one forecast for your future financial security is as risky as sinking all your cash into toilet rolls in the expectation that you will be able to offload them at a huge profit in the future.