How Investors Are Dealing With Today’s Uncertainties
Last week's stock market action will come as no surprise to people who closely follow investor behavior, particularly those who are students of behavioral finance. It will also reconfirm already entrenched adaptive expectations that have conditioned investors to buy the dip -- a behavior that has clipped considerably both the duration and extent of market sell-offs.
In a week of notable moves in the fixed-income and currency markets, including the 10-year U.S. Treasury's decline to a 2017 low and the dollar's weakening to levels not seen for almost three years, U.S. stock indices recovered impressively from a rough first day of trading. By the end of the week, the Dow Jones Industrial Average was essentially unchanged, while the S&P slipped just 0.6 percent and the VIX edged up to only 12.1. In the process, stock investors again put behind them big unresolved issues regarding North Korea's nuclear threats, significant actual and projected damage from two monster hurricanes, added uncertainties about the future leadership of the Federal Reserve, and a significant downward revision in Japanese growth.
Admittedly, there was also favorable news last week for markets. The European Central Bank revised upward its growth projections, while a surprise deal between President Donald Trump and congressional Democrats removed the specter of an October breach of the debt ceiling and the government running out of funds. At the same time, remarks from Fed officials pushed back investors' timing of the next interest rate increase, reducing the implied market probability of a December hike to just under 30 percent.
Assessed on their merits, the net impact of these developments is to cast some doubt about the world's economic, policy, political and geopolitical outlook. Indeed, even the favorable events came with qualifiers. For example, the ECB also revised down its inflation forecast, highlighting that all is not well on Europe's cyclical economic horizon. And there is a considerable difference of view among political commentators as to whether the deal on the debt ceiling enhances or undermines the probability of subsequent timely congressional approval of pro-growth tax reforms and infrastructure.
What last week's market action demonstrated, once again, was investors' willingness to set aside considerable unusual uncertainty. They remain deeply comforted by the notion that central banks continue to cover their backs, that corporate cash will continue to be ploughed into the markets via dividends and share buybacks, and, to a lesser extent, that the global economy is in the midst of a synchronized upswing. Indeed, in recent years such faith has richly rewarded investors who have been conditioned to buy the dip, regardless of its causes.
As valid as these factors may be (and there is room for debate about all three) they do not directly reduce the uncertainties posed by geopolitics and national politics. In effect, rather than try to internalize them, stock markets are essentially ignoring them -- because they are intrinsically difficult to price and because so far they have tended to have limited lasting impact historically.
This market attitude is familiar to students of behavioral finance. It speaks to elements of neuroscience and psychology that affect investor behavior and, in a desire to return to a comfort zone, can lead to overly optimistic assessments of risks. But it is also an attitude that is vulnerable to sudden large tipping points, particularly if one or more of the uncertainties evolve in a significant unfavorable fashion.
So far, investors have been right to supplement their structural and secular portfolio strategies with a good dose of tactical positioning. In doing so they have been outsourcing uncertainties to institutions (namely central banks) and an economic and financing paradigm (that of a low-volatility new normal) that has emboldened them to take on more market exposure and greater liquidity risk. To also make this approach rewarding over the long term, at least one of two additional factors must materialize over time: an improvement in underlying fundamentals that validates existing asset prices, or sufficient investor agility and resilience that enables them to navigate safely the eventual more realistic pricing of the fluid world we live in.
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Max Berley at firstname.lastname@example.org