With lockdown continuing and the tone of news flow deteriorating, it can be hard to reconcile the recent bounce in equity markets with how we may feel personally.
It is just as hard to consider these rebounds in the context of economic data, which suggests worse to come in many metrics:
This conflict between price and news is revealed in some of the framing in market commentary which, like “despite Brexit” headlines in recent years, reveals many of our prior beliefs, forecasts, and preoccupations (whether conscious or subconscious). There is a sense that many feel that stocks should be going down:
However, for most of us, it is likely to be our emotions that drive these feelings of confusion. Any honest examination of history should reveal that it is no surprise to see our expectations confounded by markets, or to see markets behave contrary to apparent news flow.
In the case of recent behavior, while we can never fully explain why prices moved the way they did (no matter how hard we try), there are several plausible explanations behind what on the surface may appear to be a disconnect between prices and economic reality.
Living in the future
The first, most obvious, point is that markets are meant to be forward-looking. Current data only matters so far as it differs from what people already believed would happen. In the case of the pandemic, as Steve wrote a few weeks ago, we knew weeks ago that macro data would be very bad, we also knew that this data should not be interpreted as it might in other environments.
We also know, that GDP is not the same as profits, and profits need not be the same equity returns. As Josh Brown wrote this week: “you can’t invest in GDP.”
Theoretically financial markets are meant to ‘look through’ the temporary, and so it should not necessarily be a surprise when they don’t behave in line with the latest data release. The question is, why does ‘looking through’ sometimes get abandoned?
A rebound in time horizon
We are often told that equities are ‘long duration’ assets and that you should ‘invest for the long term;’ but that can be very easy to forget in the face of day-to-day commentary.
We have a propensity to latch on what is going on right now to explain every twist and turn in the market, even though many investors will have far longer time horizons. Not only that, but frequently what is going on right now does begin to be the main driver of price moves.
In March it often looked like the right now was all that mattered. Indeed, after beginning to respond solely to the near term twists and turns of coronavirus reporting, it became the case that short-term price moves themselves began drive decision-making.
Amidst a desire for safety and forced selling of leveraged strategies or volatility-oriented risk models, assets began to move without apparent reference to news, no matter whether it was of long, or short-term importance. In this short period in March, all assets sold off as investors sought cash, including traditional safe havens like government bonds and gold.
This period can be considered one of ‘belief free’ investing. Investors are not selling because they have a new view on the economy, profits, or valuations, they simply want cash. This could be because of the emotional challenge of heightened volatility and an unprecedented analytical challenge, it could be to meet margin payments or client redemptions, or it could simply be because risk models and stop losses make such sales mandatory.
This type of behavior may reveal two characteristics of us as investors. Not only does an emphasis on such news flow illustrate shorter time horizons than many of us claim to have, but in periods of stress our time horizons (or at least the most prevalent time horizon exhibited in market behavior) temporarily shorten.
As I have discussed before, it seems that when we lose our faith in valuation anchors – for example, when confronted by an analytical issue that we haven’t come across before, or when earnings and other assumptions are wiped out – then following the crowd can become an appealing strategy, especially when that crowd is seeking the exit. Forced selling and trend following strategies are likely to exacerbate that trend.
Indeed, much of the price move we have seen since the lows in equity markets largely effects an unwinding of what we saw in the phase of ‘belief free’ investing in March (which can also been seen in other asset classes). In that phase there seemed to be little relationship between price and news, so why should we expect such a relationship to exist as it unwinds?
An alternative explanation is simply that forward looking news – as opposed to the macro data which will always have an element of lag even when based on surveys – is improving.
This would be consistent with the model of financial markets that most of us are presented with most often. Journalists, who don’t have the luxury of letting price moves go by without an explanation, will find reasons for the rally that are more tangible than ‘changing time horizons’ or ‘behavioural shifts.’ Among these explanations are signs of virus cases peaking, encouraging news on a vaccine, or the role of bail outs and stimulus.
These are all plausible influences, though it is notable that most of these arguments come to the fore after prices have already moved, or indeed do not remedy the arguments that were put forward to explain why prices were falling in the first place.
More likely is that the rebound in equities from the period of stress simply reveals that horizons have become more ‘normal.’ Perhaps those forced to liquidate have done so, maybe valuations have been sufficient to draw in those with longer horizons, or perhaps a fall in volatility for more random factors has become self-perpetuating. Whatever the reason we should be wary of using recent moves as an indicator of what will come next. It is better to expect to be surprised.