Wild Market Reaction to Strange Influencers
by Kent Butcher, MBA
Now that our stomachs are starting to settle from riding out the market peaks and valleys of the past six weeks, commentary is being made by investing and financial advising experts throughout the industry. These messages are focused around four common themes.
First, in our global economy, it doesn’t take much to upset the markets, driving them either up or down. In this case, the fear of spreading Ebola infection was sufficient to depress the price of airline stocks. While this news wasn’t directly related to any specific economic activity, it was sufficient to cause travel-related stock values to fall. In addition, news of slower than expected growth of the European economy teamed with signs of deceleration in U.S. retail sales growth were also contributing influences. While these factors are economic in nature, they aren’t considered to be fundamental factors that would normally cause significant movement of the market.
Second, the liquidity of the markets has been lessened. Primarily, action by the Fed to slow the rate of bond buy-back (quantitative easing), coupled with the Fed’s stated intention to curtail the program has had the effect of depressing bond yields and discouraging investment in the safety of government-backed securities. On Wednesday, October 29th, the Fed decided to discontinue this program entirely. Until returns on bond grow to an attractive level it is still believed that this illiquidity of the market will continue to exist. Further, the regulations enacted after 2008 that constrain proprietary trading are blamed for having prevented large banks from trading in a manner that would have worked to calm markets and therefore, reduce volatility. These constraints on the flow of funds into the bond and in reducing the calming effects of institutional “market makers” created an abnormal investing environment. Link this with the aforementioned global factors and it becomes difficult to control lemming-type trading, in either direction.
Moreover, lack of the “human element” in trading decisions is also being blamed. This happens when trading momentum up or down causes prices to speed past pre-set trigger points for computerized trading. As these triggers are pulled, the resultant trades exacerbate the height or depth of the market trend. It is speculated that if humans were making these trades, the application of human intellect would stop the market from going to such extremes.
Third, the long trending bull market has rewarded risk taking. Over the past year, the volume of the voices of financial experts has steadily grown, with the warning that the continuing stock price gains had no basis in the “fundamentals” of the companies or market. Many analysts were clearly on record warning that stock prices of a number of companies could neither be supported nor explained by commonly used metrics for price and dividend performance. The experts describe this condition as the market being “decoupled” from the true value and performance of the exchange-listed companies. As a consequence, stock values become increasingly vulnerable to being upset by emotion created by non-economic global news, like the Ebola crisis.
Fourth, the monetary policy of the Fed has become a security blanket for investors. In the chaos of this six-week period, the Fed attempted to re-assure the market by taking a step back from the announced plan to end the bond buy-back program next May. Soon after, a mellowing of market volatility occurred. This caused analysts to conclude that investors have come to depend on the level of certainty that this program has provided to the market. This dependence has taken the form of encouraging investors to continue to channel money toward the potential of higher stock returns while abandoning the relative safety offered by bonds. Since the Fed discontinued the program on October 29th, and with the announcement the following day of a 3.5% gain in the GDP, investors appear to have thrown caution to the wind and the stock markets have soared.
The conclusion reached from all corners is that sticking to a time-tested model of investing provides the safest harbor from market turbulence. In other words, those investors with portfolios constructed based on strategic asset allocation and who maintained them based on fundamental market analysis came through this period with the least amount of damage. With the prediction for continued volatility through the first half of 2015, investors would be wise to stick to this core investing principle. Additionally, keep your seat beat buckled tightly.
Adapted from 4 Things To Remember After Wild Market Week by Mohamed A. El-Erian.