Hello Voornaam,
Welcome to another Ingham Analytics Weekly Letter on Sunday in which we aim, inter alia, to take a step back to see wood for trees, in South Africa, and around the world.
Today, we're drilling down to the strange quirks we see in markets.
It's October. Seven short months back in February seems like an eternity with a world upended due to COVID-19. The consequences, social and economic, of policy decisions by governments to combat this pandemic are already apparent and will possibly intensify. In equity, bond, and credit markets, price signals have already been absorbed, with often distorting effects that have repercussions too.
The body of knowledge of financial markets is extensive. But you'd be forgiven today for thinking that the textbooks are broken and have little theoretical let alone empirical application.
From our point of view, human behaviour often eclipses cool, mathematical rationality. The very behaviours that were evident in financial markets in late February and through March are evident today, only in the opposite direction. The fear and panic about this new virus that spilled over into all markets have subsequently spilled over into fear and panic of missing out on a reignited bull run in equities and bonds. Securities that were pricey but not overly so in January are now substantially more expensive.
We've examined aspects of this phenomenon from time to time and revisited in a note this week entitled "Outsized Big Five", referring to the big five US tech stocks, but the analogy is as apt in bond and credit markets, which we discuss as there is a transmission mechanism at work.
Those five stocks collectively have a market value of $7 trillion - larger than any other single country stock market by quite a distance and a third of the Nasdaq Composite Index. It's as though thousands of other shares are hanging around to provide some scenery so as the big five don't feel too embarrassed by their weight. These companies appear to have been given a pandemic gift of riches whilst the proletariat get by on gruel.
There is a parallel with Prosus and Naspers, a topic we assessed this week in the note "Ant(icipating) a listing" which referred to the upcoming initial public offering of Ant Group. Tencent's WeChat Pay is a smaller but considerable competitor to Ant's Alipay. Whilst Prosus and Naspers trade at stubbornly large discounts to the see-through value of the Tencent holding, both are outsized too in the goldfish bowl that is the JSE.
In the 1960s the efficient market hypothesis (EMH) took root. Eugene Fama's paper "Random Walks in Stock Market Prices" dated 1965 was seminal in this regard.
This theory posits that security prices fully reflect all available information. If true, in a world of efficient capital markets, it can't be assumed that making money by trading securities is easy. The plethora of data we have today compared with the 1960s would suggest that it is even more true. Everything that could possibly be known now and in the future must surely be priced in? Alpha, or outperformance, isn't possible?
This EMH was the theoretical basis for indexation, a passive tool that simply tracks the ups and downs of shares in individual companies as represented in an overall index such as the S&P 500. But that excluded other securities such as fixed income. Only from 1993 did more exotic avenues become available through the exchange traded fund (ETF).
The theory is defendable but in practice open to question.
An obvious question is if markets are so efficient and all-knowing, why then do we have such enormous volatility and irrational price action? Isn't it the psychology of today rather than some indefinable reasonable future? Why is the price of Tesla today worth five times what it was on the 2nd of January when it's making no more cars than anticipated in January?
Most empirical observation relates to the US, the deepest and most liquid markets in the world, and less to other markets that lack this and the very big hinterland of institutional and retail investors in the US. We see this daily as markets outside the US take direction from the US. Because of time zone differences, the ASX market in Sydney reflects what happened the previous day in New York whilst European trading in the afternoon mimics opening in the US.
Passive investing is dependent on active investing - real people or computer algorithms initiating a trade. If 100% of the market was passive, then by definition there wouldn't be a market. Rebalancing of indices to reflect underlying market movements is itself a result of the activity. Tech stocks today have a larger weight than they did in January, there is nothing passive about that.
In March this year index funds simply reflected what was happening to the active buying and selling of underlying shares and in fact probably accentuated movements as investors in mutual funds dumped units, which in turn required the manager to sell. Redemptions to cash require someone to push a button and realise assets for cash.
As we mention in our note on the big five, for every seller there must be a buyer, and bear markets end when everyone who wants to sell has done so. This is what happened in March, in fact, whether you had an ETF or shares in individual companies there was indiscriminate selling to cash, with good and not so good shares in a downward vortex.
The bear market of March was unusual - and short-lived - but a bottom was hard to gauge such was its ferocity. But looking back six months we can date that bottom to 23 March. If Nathan Rothschild were still alive, he'd have been buying quality securities at that time amid panic selling, as he did during the Battle of Waterloo with British government bonds.
The rise of ETFs has encouraged excess trading and a short-term approach to investment management - ETFs trade more intensely in times of market volatility, as is the case now with the VIX (fear gauge) in the US remaining elevated. Retail activity has exploded during lockdown. The active trading of ETFs is also part of the process of liquidity and market-making to ensure that fund prices are in alignment with the prices of the component pieces.
Markets typically reflect a prevailing consensus or groupthink. Portfolios that do well over time almost always deviate from capitalisation weights, a deviation from the consensus that requires reflection, sound judgment or common sense, expertise in evaluation, and level-headedness.
EMH was steadily challenged in academic circles. The random walk hypothesis requires that the volatility of sequential price movement be constant; the sharp increase in stock market volatility since the 1960s would be sufficient alone to invalidate the hypothesis. The EMH is strangely silent on volatility. Studies show that volatility estimated on longer timeframes at share prices meaningfully underestimates volatility estimated from weekly movements.
If all information is incorporated in prices, there is no incentive to trade and no mechanism though which information can be reflected in prices. The marginal cost of making a trade is not countered by a marginal advantage. But share prices are in practice noisy, and this can enable a better-informed trader to profit from arbitrage or under/overvaluation.
Securities - and foreign exchange - markets volatility with booms and busts, that obviate any semblance of EMH, prompted the study of behavioural factors influencing prices. Behavioural finance is now standard in academic literature and in shaping thinking on markets.
EMH is a general equilibrium theory in capital markets characterised by informed and rational agents whereas cognitive rationality isn't uniform. People tend to extrapolate based on limited evidence, which makes for an ill-informed decision. Earnings growth might be extrapolated irrationally to suggest that a company could grow at x% indefinitely.
Bias interferes too, investors can become so besotted with their investments that they lose objectivity and may even stick with it in a death spiral. We shouldn't underestimate the role of wishful thinking, ascribing a probability to the desired outcome.
As we could see in March, people react more emotionally to losses than to gains, and as losses mount those paper losses are converted to cash losses. Gains lead to further gains when there is momentum, until suddenly there is no momentum and the whole cycle starts again.
The madness of crowds leads to the formation of bubbles in asset prices that can be persistent. To paraphrase Keynes, "markets can remain irrational longer than you or I can remain solvent."
In conclusion, a medical qualification in psychiatry may probably be better suited to running funds and trading securities than a degree in finance, with the advantage of being able to go back to private practice if you feel like it or if the sheer madness finally gets to you.
Thank you all for visiting us.
