The illusion that one can either predict or get ahead of cycles, or predict when they will end is why most investors underperform the market. Markets are driven by human emotion, and it is human emotion combined with the supply and demand dynamic that determines price. Therefore, pricing is independent of anyone’s perspective about “intrinsic value.” Markets are based on price, price is based on supply and demand, and that dynamic is subject to abrupt changes based on the whims of small numbers, and sometimes exceptionally large numbers, of investors. Human behavior controls the markets. Optimism, pessimism, psychology, fear, conviction, and resignation all play a role in adding to volatility and uncertainty. Frequent and intense volatility is here to stay. Market movements really can’t be predicted unless they are at extremes when prices are at absurd highs or lows. But, picking the high or the low is a fool’s errand. Understanding and profiting from volatility, managing risk, and believing in a sustainable investment model is still the best strategy.
Prepare for more frequent and extreme volatility. New and powerful influences, ranging from social media and financial technology to algorithmic trading and esoteric valuation models, will increasingly upset market stability and bring unprecedented rewards and unpredictable disaster.
Predictable market conditions will be upset by sudden unpredictable movements.
Financial markets can be predicted reliably only when the world does not change. Even during periods of stability, judgment based on expectations and assumptions as much as hard facts and economic analysis, form the basis for buying and selling decisions. Market crashes and financial crises are a continuing and breathtaking reminder that markets are irrational and uncertain. Taken to an extreme, the combustible combination disrupts global markets and societies. New analytical tools and technologies appear to make worrying about unforeseen risks obsolete. But this naïve belief in technology’s ability to understand and predict catastrophic risk is a fundamental cause of that very catastrophe.
Stability is illusory because in an uncertain world, unforeseen changes can have seismic effects. The pandemic is only the latest example, but there are always greater risks inherent in markets than is acknowledged, and most investment strategies do not accurately reflect the risk that certain investments are assuming for a given return. Safety can be an illusion if the risks are not well understood, both systemic and undiversified.
As we have seen, oversight, regulation, or any sort of self-imposed moderation will continue to be ineffective or nonexistent, and always trail behind the most dangerous and detrimental market developments. Financial weapons of mass destruction continue to multiply and are now available via smart phone in everyone’s pocket. Expect more and greater turbulence.
Clear and coherent markets, free from political agenda, bad compromises, and ineffective regulation is almost nonexistent. The consequences are usually pyrotechnic. It is not as if the world hadn’t provided ample warnings about the risks associated with irresponsible finance. History has centuries worth of such examples, but even looking at recent events over the last 25 years is illuminating.
In spite of Alan Greenspan acknowledging the “irrational exuberance” of the markets in 1996, stock market valuations continued to rise. The warning signs of unstable economies were believed to be localized and the broader markets decoupled from this turbulence. This was naïve thinking then and outright irresponsible now.
The idea that markets are uncertain, and consistent prediction is essentially impossible, is not new. John Maynard Keynes published a book on probability and uncertainty in 1921, with this concept of uncertain and irrational markets forming the basis of his general theory of financial markets. So, years before the stock market crash of 1929, and almost every 10 to 15 years afterward, the cycle of financial crashes and panics was predicted by a well-publicized thinker, and then, as is typical, ignored. The lesson is simple, and Keynes laid it out 100 years ago: markets seem rational but only during periods of stability. Markets are uncertain. Predictive models work most of the time, and that is their fundamental flaw. They will fail. Investment models that account for uncertainty and failure succeed in the long term.
S&P 500 stock market values are experiencing the same volatility as the first half of 2020, the start of the Covid-19 pandemic (based on the 50 largest value movements as a percentage of the index’s total market value). These dramatic movements show that market volatility leads to big price movements in stocks, both up and down. There are a couple of factors combining to enhance this turbulence: The popularity of the momentum trade (buying stocks that are rising quickly and dump the relative losers quickly). Decreasing liquidity (fewer buyers and sellers for the other side of trades). Both factors magnify the market’s moves in either direction.
You cannot escape physics. The value of every investment starts at zero. Entropy is our natural state (thank you to the Second Law of Thermodynamics) meaning that we are constantly fighting the destruction of value. There is always a force, equivalent to gravity, pushing an investment down. Value is created by the efficient use of capital and the created, sustainable competitive advantage. Consistent investment in a thoughtful portfolio will create sustained value, but it is work, and you will always be fighting natural physical forces. One recent example is the financial crisis of 2008 to 2009. 40% of the average equity value was destroyed in this time. However, if one invested consistently at the height of the market and continue to invest through the crash and then ultimate recovery, and investor still earned over 9% annually. Thoughtfulness, consistency, patience, and determination is the most effective way to fight gravity and thermodynamics. The most important way to fight physics and the ultimate effect of gravity is to determine what you are looking for first. Highlight growth, disruption, sustainability – what will have a long-term value creating effect. What sectors make the most impactful difference? Recently, as we look at technology, biotechnology, and other important sectors, we see above average returns because of the impactful nature of the sectors. But technology is also permeating finance (Fintech) and entertainment (streaming services) that are disrupting incumbents and creating disproportionate value to the new entrants. Is this sustainable? Will the disruptors capture value, or will more established companies ultimately win? Observation, questioning assumptions, testing models, and assuming no knowledge regardless of historical experience are the only cures for gravity.