Investors are prone to attribute human characteristics such as intelligence to the stock market – as in “what’s the market trying to tell us about the outlook?”
For some reason we seem to fall for this anthropomorphism more when the market is in freefall, as if it is even better informed when things are going wrong. I don’t believe it is.
Ben Graham, Warren Buffett’s mentor and the source of a great deal of wisdom about investing, went so far as to talk about Mr Market, a business partner who can be counted on throughout the trading day to quote you a price to buy your share of the company you both own or sell you his.
The grain of truth in this description is the fact that the market reflects the collective thoughts and actions of all investors.
Where it goes too far is in suggesting that the market’s intelligence amounts to more than the average insight of individual investors.
As Howard Marks, a thoughtful US investor, pointed out in a note to clients last week, people of all different levels of ability buy and sell investments, but the market doesn’t distinguish between the ones who have insight and the ones who don’t, especially in the short term.
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The market price merely represents the average view, weighted by how much money backs each position – no more nor less.
This matters because many of the conversations I have at the moment are variations of the scary thought that the market might know something that the rest of us don’t.
Traders on the New York Stock Exchange (NYSE) at the start of the trading day
I don’t believe the market tells us anything more than the current consensus. In Graham’s words, it’s a voting machine in the short run not a weighing machine and, as the chart shows, it changes its mind on a regular basis.
In times of market volatility, people forget this and believe instead that price falls are some kind of canary in the mineshaft, predicting recession or worse, and so fuelling a self-feeding downward spiral.
So the market is no more intelligent than its participants. When it comes to sentiment, however, it does seem to add up to more than the sum of the parts. Two plus two does equal five when it comes to the market mood.
Put a thousand slightly nervous people in a room and it’s a small step to creating a stampeding panic. People feed off each other’s emotions and really do make each other more crazy than they individually are.
Actually, if you are an active stock market investor you already know this. If you thought the stock market really did have some special insight then you wouldn’t spend your time trying to decide when it had got it wrong, to try and buy low and sell high at the extremes when the collective view of other investors has become too optimistic or pessimistic.
By definition then, if the market is no more intelligent than its investors but it is more emotional than they are, it is a pretty unreliable guide to anything.
We should learn to use the market’s tendency to overshoot, not allow it to control us. The difference between successful investors and everyone else is precisely this insight, although it is a lot easier to describe than to implement.
So if the market is not telling us something about the future, what is going on at the moment? What has caused prices to tumble in the first three weeks of 2016? Here’s one suggestion.
Right up until January 4, sentiment was pretty good, there was even something of a Santa rally in the days running up to the holidays. In the new year, however, someone started selling shares heavily and others quickly followed suit. Who might that have been?
One suggestion is that sovereign wealth funds, government-backed investors in oil-producing countries and export-led economies like China, started selling at the turn of the year to plug the gap left by the tumbling oil price, to support state spending and to prop up depreciating currencies.
The impact of these sales was exacerbated by an absence of corporate buyers of shares as companies put buy-back programmes on hold during the full-year results season.
It was then exacerbated by trend-following speculators, short-sellers who hoped that nervous investors would follow suit to make their negative bets profitable.
No one really knows, but if the sell-off really is technically and psychologically driven rather than reflecting the solid, if uninspiring fundamentals of the global economy, then prices could rebound sharply as they did after last summer’s sell-off.
Don’t get caught in the snap-back.
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