Are asset markets “pausing for breath”? Since the relatively dramatic moves in many markets in the second half of last year, a lot of commentary suggests that things feel less eventful so far in 2017.
There are a number of biases evident in this view. Such commentary is hugely myopic and excessively focused on the US. It is largely the range bound nature of US Treasury yields and the recent halt in US equity gains that investors are looking to explain.
This view of the world ignores the fact that there have been year to date gains of 10% in the major equity markets of Spain, Hong Kong, India, and gains of over 5% in Mexico, Brazil, Germany, South Korea, Taiwan, and Singapore (which are even greater if you factor in currency gains).
The language itself is also revealing. As believers in behavioural finance we have no issue of assigning human motivations to price action, and Benjamin Graham’s “Mr Market” metaphor (page 12, here) is a great framework for thinking about how you should deal with volatility. We also believe that there can be phases immediately after valuation anchors are challenged in which markets move into a “holding pattern” as investors digest shifts in beliefs and fundamentals. I also wrote last month about how greater uncertainty about how to value assets can be associated with both lower volatility and trending behaviour.
However, when journalists or other commentators describe temporary quiet periods as “pausing for breath” or the “calm before the storm” it is often telling you about their personal beliefs about the future and nothing to do with what is driving prices.
Waiting for a setback
The major bias the “pausing for breath” narrative reveals however, is an implicit belief held by many that we are due a setback. I have previously discussed the ongoing scepticism about the nature of the price action in the last six months (for example here and here).
This scepticism manifested in how macro data is being interpreted. For example, in the last few weeks, several commentators have pointed to the fact that recent macro surprises have been driven by forward looking and sentiment-based measures (so called “soft data”), while “hard data” (typically payrolls data, construction and consumer spending, industrial production, the housing market etc.) has lagged.
This has been interpreted as meaning that human beings within the economy (and by extension asset prices) are getting ahead of themselves and that the “hard data” is more real. The gap has also been used to explain the large difference between the New York Atlanta Feds’ “Nowcast” measures of GDP (as discussed by Tristan here) because the New York measure incorporates more soft data in its measure, whereas the lower Atlanta measure focuses on hard data.
Interestingly, the exact opposite situation has been used to justify caution in the UK. In the period after the Brexit vote, hard data was surprising positively while soft data was disappointing.
However, although this represented the opposite state to that currently existing in the US, it was also used as evidence that investors should prepare for a setback. In this case the argument was that the hard data was lagging, and that the soft data was more real because more effectively captured the likely impacts of Brexit. Steven alluded to this view in his piece on Article 50.
It is possible that both the US and UK arguments can be true at the same time. But the reality is that it is very dangerous to base investment decisions on them.
Macro data are in the most part sample-based and bear only a loose resemblance to what is going on in the real economy. Trends and extremes are important but short term variations are of limited use at best. Moreover, Steven has discussed the huge role played by macro data revisions. In the UK for example, the “double dip” recession was ultimately revised away. We don’t even know if the data is correct, let alone how useful it will prove to be as investors (GDP is not profits, and only long term profits as opposed to cyclical trends drive investment returns).
We see what we want to in the data
Today’s environment suggests continued scepticism and a desire to disbelieve stronger macro and profits data. It also shows that investors expect to see short term setbacks. This runs contrary to the narrative that equities are displaying bubble-like behaviour.
The example of the differing interpretations of hard and soft data illustrates that individuals, and markets, can respond to the same data in very different ways. As investors, trying to think about whether these differences tell us anything about possible errors in market pricing is an example of the type of second-level thinking that could form a plausible edge.
But there has also been an observable transition in sentiment evident revealed by this language. When investors refer to “a pause for breath” or a setback they are now frequently talking about these as opportunities to enter the market. In much of the period since the financial crisis the idea of “calm before the storm” generally presupposed a major crisis. These changes in themselves could be significant; but history suggests that framing decisions in terms of the likelihood of short term setbacks is not the path to strong returns.