It is always staggering how quickly markets appear to move on from one issue to the next. Only six months ago (or 45% ago in Nasdaq-time) most investors (including us) were petrified as to the implications of the pandemic. Safety and insurance were the order of the day.
In only two quarters, attitudes have changed dramatically, both with regards to perceptions of risk and the issues which attract our attention. The pandemic still dominates coverage, but the desire for investment safety seems to have given way to return-seeking, and financial markets seem to be finding new topics to worry about: most notably the US election.
How do these changes happen and can it tell us anything about how opportunities might be created for investors?
Somebody bring me back some money please
The transition from a desire for safety to return-seeking is an emotional one that comes in stages.
Once human beings have formed a view, they don’t like to see it confounded, and it takes time for them to change their minds. Many formed a pessimistic view in Q1, and so in the face of asset prices recovering from the March episode in Q2 the tendency was for scepticism and dismissal.
But over time (and with repeated contradictions) we tend to reinvent what we used to believe, and asset prices have a tendency to force us to do this. Before long, we start to believe we weren’t as scared as we thought we were, and developments that we formerly question begin to seem ‘obvious.’ Consider the unlikely bedfellows of gold, the Nasdaq and thirty-year Treasuries, each of which is up 25-30% so far this year:
We create stories for why this is obvious, even if they seem contradictory: “Of course gold would go up, people need safety and the policy response is bound to be inflationary,” “yes, inflation should mean Treasuries sell off, but they’ve gone up because policy rates are never going to rise,” “yes, the Nasdaq couldn’t really be considered a ‘safe’ asset but it’s obvious more working-from-home will offset the impact of growth declines in aggregate (though no-one knew this in March).”
We can construct such narratives, and they may have some validity, but more likely is that we are finding a story to fit the price moves rather than doing any actual analysis. This is dangerous, because we can talk ourselves into chasing returns for ill-thought out reasons.
Even worse, we might be even be more desperate to believe, in our haste to recover earlier losses or make amends for returns we have missed out on.
It’s all about progression
An equally dangerous influence of our emotions is the tendency to always move on to the next issue, rather than taking stock and reflecting on our decision-making in the past. The new always feels more urgent, and intellectually interesting.
Hence we begin to focus on the US election, even though last time round the most sensible analysis was a) wrong about the outcome, and b) wrong about the impact on markets of the outcome that did occur.
Today, the polls suggest a Biden victory. For what it’s worth let’s compare them to the run up to 2016:
The gap in favour of Biden is greater than in favour of Clinton at the same stage, but Clinton had seen a bigger lead in the April leading up to the vote.
What is an investor meant to do with this information? We could probability weight the chances of a Biden victory, factor in likely Democrat policy, adjust for the chances of it getting passed and consider how it will be implemented in practise and then come up with a possible impact on company earnings, Fed policy and US inflation…
But to do this is ‘other things being equal’ thinking in the extreme. If 2020 has shown us anything, it is that there will always be other forces outside of what we think is important today that impact markets.
Hold up, freeze
If markets were efficient they would incorporate all publicly available information into asset prices all the time. They would ‘pay attention’ to everything of relevance and give the right weight to each according to its likely impact on asset prices.
We certainly know that human beings aren’t efficient. A paper by Thali Sharot and Cass Sunstein earlier this year illustrated what many of us believe: that individuals will pay too much or too little attention to things based on emotional motivations.
And it often feels that asset prices are more like the human world suggested by Sharot and Sunstein than the efficient markets model of Fama and French. The evolution of the last three quarters seems to suggest this.
There are things that are important that don’t enter into our thinking and things that are not which can dominate. We need to be aware of this tendency and avoid chasing the issue of the day. More importantly, we need to consider whether such short-termism is at play in markets – if it is, and we can avoid getting caught up in it, then opportunities should follow.