A market defying fundamental factors can continue to do so for long periods. It’s not the fundamentals that count, it’s the elements that capture the market imagination that determine short-term direction.
From late March to early May share markets around the globe rallied strongly. Index gains exceeded 40% in many cases. The US Nasdaq 100 index hit an all-time high. At the same time, macro data and company reports painted a grim picture of economic damage and high uncertainty. How can share market performance diverge so radically from the empirical evidence, and what can investors do about it?
Markets are described with numbers. This fact can fool investors into thinking that markets are somehow mathematical, or scientific, or at least logical. The reality is different. The market price for any security represents an equilibrium between those who think it may rise, and those who think it may fall.
In other words, a price is a product of opinion. It’s a sincere opinion, as investors and traders are putting their money on the line to express their view, but a price is the net opinion of a crowd. Further, in forming those opinions, market participants are not assessing the present, but the future.
This is the starting point for the recent divergence between data and share market performance. It was widely reported that the buyers that drove the five-week rally were “looking through” the clear evidence of economic damage to a better environment ahead. They expected a v-shaped recovery in economies and markets after lockdown measures were lifted. Benjamin Graham (Warren Buffet’s inspiration) reportedly said:
“In the short term the stock market is a voting machine, but in the long run it is a weighing machine”.
It’s clear that many investors were “voting” for a strong economic comeback once the Covid-19 clouds cleared. The premise of Graham’s observation of the stock market is that “fundamentals will out”. That at some stage the true economic drivers of shares prices will hold sway, and that share prices will rise (or fall) to match the fundamentals.
The underperformance of value as an investing style over the last decade undermines the authority of the statement. Broken clocks and semi-daily accuracy come to mind. What is important to note is the market swung with the story. When the dominant market narrative changes, so does the market.
The prevailing narrative up until last week’s US Federal Reserve statement was the v-shaped recovery. Although the Fed maintained its accommodation, and hinted at increasing its asset purchases, stocks are lower. The reason is that the Fed refused to endorse the central tenet driving the markets. Instead, its economic projections were sombre. Analysts focussed on the Fed’s expectation of unemployment at 9.3% at year-end to unpick the quick recovery story.
The market narrative is now shifting. Reports of re-infection and secondary outbreaks are rising, from Bremen to Bakersfield and Beijing. The recent pressure on share markets reflects the shift in the main market story. The risk of secondary outbreaks was canvassed from very early on in the crisis, but was largely ignored. In other words it’s not the fundamentals that count, it’s the elements that capture the market imagination that determine short term direction.
This is a subtle yet important distinction. Markets change direction when the market narrative shifts. Surprises result in the biggest moves, but by definition surprises are unpredictable. However there are many scheduled events and information that have the capacity to change the market story.
The first step in anticipating market moves is understanding the current narrative. While there is always doubt about the future, when sentiment swings to all-positive or all-negative, it is an indication that the market is vulnerable to a reversal. The expectations of a v-shaped economic recovery, with no secondary outbreaks and falling global tensions may have been peak positive.
A market “defying” fundamental factors can continue to do for long periods. There must be a trigger to change the market mood. While left-field events are very difficult to predict, central bank announcements, government policy shifts, economic data and company reporting often occur at pre-determined dates. Checking the market calendar should be a part of every investors’ routine.
The market impact of new information doesn’t depend on the facts themselves, but on how it changes the story.