Misbehavioural Finance

By Stephen Black & Emma Black (Managing Director and Portfolio Manager at Tier One Capital) 11 July 2013

It would appear that there are enough swings and roundabouts in the markets these days to fill each and every playground in the land many times over. What's interesting to note however is that the current climate is one where the swings and roundabouts are not adhering to the time honoured rules of how the markets are supposed to function and specifically to how they process good and bad news.

On Friday there was a raft of positive data including better US jobs numbers showing job creation to the tune of 195,000 extra positions as well as corporate confidence running at the highest level recorded since May 2012, as measured by the BDO Optimism Index (and indeed running at post-credit crunch highs earlier in the week as measured by the quarterly survey of the British Chamber of Commerce). There was no overtly negative news from China or Portugal which are both suffering mini-credit crunch blips in their respective economies. Why then did the markets go down despite this? The reason is that the usual connection between good economic news being seen as positive and therefore driving the markets upwards has been usurped by a worrying addiction to stimulus. Good news is seen as being likely to bring with it an end to the 'easy win' of growth through further stimulus and the markets concern in a lack of growth without this artificial aid could not be more clear: good economic news today is not being deemed strong enough to outweigh the anticipated negative effects of stimulus withdrawal.

So how are markets supposed to function? There is a plethora of research that has aimed to explain, and continues to debate, this exact question from a financial and economic perspective, as well as politically, economically and sociologically. Financially, studies have assessed how investors and advisors have responded to market events (i.e. catalysts) over time. The foundations of this are based on the fundamental assumption that markets are efficient, meaning that market prices should react instantly to the arrival of new information only. All past information should be included in prices to satisfy the lowest form of market efficiency, weak-form. The second level of market efficiency, termed semi-strong, requires that all current information should be impounded instantly as soon as it is announced publicly (i.e. earnings announcements, quarterly updates, managerial turnover, and so on), such that there should exist no profitable time-lag (i.e. there should not, for example, be a gradual increase in a firm’s stock price following a positive earnings update but rather the market should instantly adjust the stock price upward to reflect the new valuation of the stock). And finally, the strongest form of market efficiency, termed strong-form, proposes that market prices should include all past, public and privately-held information (i.e. there should be no scope for insider trading). These three forms have served as the basis of financial models since being established by Eugene Fama in 1963 and 1970.

The early evidence over the validity of market efficiency tended to largely support the weak and semi-strong forms. On average, profits were eroded from trading on past information once transaction costs were accounted for, while research into the speed of adjustment to new public information arrivals found that this took place in a reasonably fast timescale. Furthermore, while insider trading was an evident violation following the US mid-eighties scandal involving Michael Milken, Dennis Levine, Martin Siegel and Ivan Boesky, regulatory action and the following legislative enactments during the latter part of the eighties and moving into the early nineties largely resulted in support again of market efficiency.

It has been since 2000 that we have really seen the debate over the validity of market efficiency gain pace. A growing area of research, termed Behavioural Finance, has specifically applied psychological traits to financial participant decision-making processes. These traits have included reactions in the market to catalyst events (i.e. to assess if there is any evidence of an overreaction or underreaction), mood (commonly referred to as sentiment), mental accounting effects, recallability, loss aversion, and many more. Perhaps the most important for understanding the current climate is investor mood (i.e. whether or not market participants feel good or bad, or optimistic or pessimistic, about the economy) and recallability (i.e. how much importance people give to recent events or in other words how much they recall what has recently happened).

With technological advancements leading to social media and the like, we are bombarded with information and headlines such as ‘RBS gains as economic optimism aids banks’ (FT Online: 08-07-2013), ‘Ignore the pessimists – central banks are helping’ (FT Online: 27-06-2013), and ‘China: the case for commodities optimism amid the gloom’ (FT Online: 10-06-2013). The hashtag #Sentiment regularly features in investment tweets. News announcements filter very quickly through social media channels such that information is now spreading at a very rapid pace indeed. This mass proliferation of people’s moods and feelings moving forward has had the effect of moving prices away from fundamentals as participants have begun to trade on mood rather than logic.

Economically the data supports this. Profits have been shown to be extracted from trading within 15 seconds of CNBC’s Morning and Midday Calls while mood has led to extreme gains and losses following sporting wins and losses, good and bad weather, temperature increases and decreases, lunar moon cycles, and many other variables. All have been shown to have a significant impact on market mood leading to significant investment opportunities as prices have become inefficient.

The ease with which people can remember the pain of significant market falls has bolstered this impact even further. The 2008 crisis, the Eurozone debt crisis and Quantitative Easing remain at the forefront of peoples’ minds. Each time new information, be it good or bad, enters the markets, investors and their advisors recall recent events and recalculate potential outcomes moving forward. The 195,000 US jobs created should have led to positive returns in an efficient market but with recallability and mood, markets reacted negatively on the expectation that the Fed removing central bank support could happen sooner rather than later (despite the fact that in actual effect, the QE inserted remains largely an electronic transfer that has not hit markets in terms of money supply as velocity remains low and thus the impact would only be truly felt on bank balance sheets, not in the pockets of individuals). The result is that we have increasingly volatile markets, prices that are deviating wildly from fundamentals, and an increasingly precarious situation over how to invest in this increasingly evolving and dynamic environment.

So how long will these traits continue to exert an effect on market conditions? From our perspective, these are here to stay as they have been present undoubtedly for hundreds of years. Mood always has had, and always will have, an impact on investment decisions. The mass hysteria of the Tulip and Bulb Craze of the 1600s was a clear example of how mood can affect demand and ultimately prices. Moreover, it is natural for investors to recall previous events as psychologically, there is a mentality to use what has happened in the past as a qualitative foundation for what will happen in the future. The difficulty however, is that while that psychologically is true, it is not wise to make an investment on this basis. While events can exhibit similar characteristics, the impact and perceptions will always be different and to base your investment on historical information is a risky platform for your portfolio.

Right now, volatility is likely to continue as a persistent concern. The looming question of when QE will be removed from the markets  remains, while there also remains the riddle of the future of the European Union, the effects of Japanese Abenomics, the political turmoil of the Gulf, the re-emergence of inflation in Brazil, the slowdown of China, amongst many others. In this interesting period, contact us to speak to a Tier One Capital advisor to learn how we can help you to manage your investments during this turbulent time.