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Market drivers - sentiment, positioning and strategy

When traders checking the overnight action ask “what the hell was that?” it’s time to question the market environment.

Recognising current market conditions is an important contributor to investing success. There is no one investing style that is successful throughout the market cycle. If there was, every investor would use it. The underperformance of “value” investing in 2018 speaks directly to this phenomenon. Does the poor year suffered by many value investors mean that this style of investing is dead? Probably not.

Market action that defies expectations can be a signal of a changing investment environment. In recent weeks international and local markets have at times moved substantially on no news. At other times they have reacted to events in surprising ways. Of particular note is share market performance since the start of the year. Major issues such as the China / US trade dispute, the US government shutdown and concerns about the global growth outlook remain unresolved. Yet from lows between Christmas and New Year, major markets are up 7%-12%.

Despite the apparent contradictions, there is logic to the current market action. Two factors in combination can not only explain the effect, but could also help investors make better decisions.

The first is the interplay between growth and interest rates. Globally, central banks are shelving their stimulus programs. They’ve halted or are winding back money injections, and are preparing to normalise monetary conditions. This means a draining of the extraordinary liquidity of the last decade, and higher interest rates. However central bankers are very concerned that this tamping on the brakes of the global economy could cause a stall or a crash, and are therefore generally only willing to act when there is clear evidence of more robust economic conditions.

This brings a good news / bad news paradigm to news and economic numbers. A release that shows stronger growth is good news, but the potential for it to lead to higher interest rates is bad news. Similarly, weaker growth is a negative, but the potential it brings for lower interest rates is a positive.

Secondly, the market argument about growth in the 2020 relies less on hard evidence and more on conjecture. When the debate is about what’s happening right now, every data release informs the discussion. Where the debate is about the distant future (24 hours is a long time in markets – 18 months an eternity) there is less solid information to support those on either side of the market divide.

One implication of these market drivers is the potential for both higher overall volatility, and higher volatility of volatility. There could be periods of extreme movement, followed by calm, followed by more swings. It’s likely to be a tough time for frail or nervous investors.

Another important implication is that sentiment and positioning are now more influential factors. It is difficult for investors to gauge actual positioning – the millions of market participants worldwide means the aggregate position is almost impossible to know. However market prices move on the balance of buyers and sellers. Where there is sustained move in either direction, it can be a good indication of the overall positioning, and alert investors may look for a push back in the opposite direction.

Sentiment may be easier for investors to track. Staying in touch with mainstream media reporting informs current sentiment, as broader media groups tend to reflect their audience. Social media may also give a sense of prevailing sentiment, although care should be taken with more extremist sites with names like ZeroSense and Cot Hopper. As a rough rule of thumb, the more conspiracy theorists, the less useful.

Successful investment strategy may require more contrarianism this year. One view is that overall it looks a lot like another broadly sideways year, with neither boom nor bust on the agenda, driven by reasonable growth and spiced with heightened fear. A possible approach is to doubt the extremes of sentiment and market swings, buying as the world is ending, and selling on any “all clear”.

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