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Saturday 21 March 2020

Markets are a Confidence Trick

The Downside of Paradise
Many investors are experiencing the real downside of stockmarkets for the first time. Suddenly they’re no longer placid, happy holiday resorts where riches gently roll to shore simply by waiting. A volcano has erupted and everyone is running around with their hair on fire stealing each other’s coconuts and hoarding pineapples.

Of course, paradise always had a lurking dark underside and even an unexpected eruption will eventually lead to vigorous green shoots appearing in the fertile volcanic ash. However, people don’t really think rationally about these things – their behaviour is dictated by how confident they feel and right now certainty is not available. Well, things will get better, but we have a ways to go yet.

Risky Returns
When economists and analysts talk about market pricing they usually talk in terms of risk. Overall, stocks provide inexplicably high returns compared to the so-called risk free asset – that’s a short dated Treasury bond to you and me. To explain this to us some idiot will generally talk to us in soothing terms about the idea that this difference is because stocks are riskier and the returns less certain.

Yet history tells us the returns are very certain. Stocks outperform over all reasonably long periods even though they will, at least once a decade, go through a period of startling volatility. And “risk” turns out to be something economists can’t define. So really the explanation is baloney – essentially what we’re being told is that stocks outperform because of some magic that no one understands but which is dressed up in an impressive sounding name to convince us otherwise.

Volatile Advice
Sometimes economists equate risk with volatility. Here’s what Warren Buffett has to say about this:
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.

‘Nuff said. Let’s move on.

Confidence Tricks
What really drives markets is confidence. They are, in many ways, a gigantic confidence trick. When people are optimistic about the future they bid stocks up because they can’t imagine that things will be any different. That’s been the case for nigh on a decade and with interest rates at multi-generational lows lots of people who otherwise wouldn’t invest in stocks have been pushed to do so – and discovered how easy it is to make money.

Only now they’re also discovering how easy it is to lose money. As COVID-19 sweeps inexorably across the globe markets have been bouncing around like a kangaroo on a Space Hopper. With no certainty about the future confidence has collapsed and what we’re seeing is what always happens when markets are seized with indecision – lots and lots of volatility as stock prices soar and drop. It is a human characteristic to seek explanations for events – which is why we see lots of talking heads confidently detailing why various stock movements are occurring. But these are unusual times and the chains of causality are not always obvious. 

Rhyming Markets
Behind the scenes institutions are dumping stock to raise liquidity either to fund margin calls or prepare for sizeable redemptions. Speculators are shorting stocks, leading to them falling precipitously, and then closing their positions, leading to equally startling rises. Prices are – quite literally – all over the place as the uncertainty makes it hard to establish logical prices and, in place of this, we’re seeing behavioural pricing based on herding driven by the level of fear in the marketplace.

Every market crash has its own trigger and follows its own path, they may rhyme but they never quite repeat. This one is, in the technical speak of economics, ‘exogenous’ – caused by factors outside of the financial ecosystem. Ergo, financial measures alone can’t fix it and no matter how much central banks intervene they can only provide a supportive environment, they can’t stop a coronavirus from spreading.

Exceptional Actions
In these exceptional circumstances governments are taking exceptional actions. Not always in any kind of consistent manner but, to be fair, the evidence is changing on a daily basis. The recent research from the UK’s Imperial College suggested that without suppression measures over half a million Brits and over 2 million Americans will die:
In total, in an unmitigated epidemic, we would predict approximately 510,000 deaths in GBand 2.2 million in the US, not accounting for the potential negative effects of health systems being overwhelmed on mortality.
Adopting suppression measures - closing businesses, getting people to stay at home, implementing social distancing - can reduce those numbers by a factor of five. And, by reducing the pressure on health services, they will also serve to reduce consequential deaths - people who die of things other than COVID-19 who couldn't be treated because there were no available resources.

One-Way Ticket
In the middle of this, though, central banks have essentially just written stockmarkets a one-way ticket – upwards. Dropping interest rates to zero virtually guarantees that stocks will soar when the virus restrictions are lifted. In the middle of the crisis, with confidence levels through the floor and volatility through the roof it’s understandable investors aren’t able to reflect that in their investing decisions, but barring some kind of catastrophic collapse of the banking system – which, let’s face it, is always possible given the shortsightedness of most bankers – there really is nowhere else for people to put their money.

Clearly that’s not a blanket positive. Companies in sectors directly impacted by the extraordinary measures being adopted – particularly in travel and leisure – are facing an existential crisis which they may not survive even with government support. Companies carrying high levels of debt are seriously at risk as equity markets are essentially closed and lenders are starting to hoard cash against the unfolding crisis. There will be unexpected corporate casualties through chains of connection that are as yet invisible and it’s likely that some behaviours will change forever, particularly where remote services can replace face to face ones.

Stay Safe
In short – there will be winners and losers. But to become rich going forward all you really need to do is stay alive and avoid most of the losers. Of those two things the former is by far the most important and should be everyone’s overriding concern right now. However, if you want to distract yourself while self-isolated you could do worse than start filtering for good companies with low levels of debt and business models that won’t be impacted when life returns approximately to normal.

Confidence will return, markets will start to function again and life will go on. Invest carefully but, above all, stay safe.


  1. where have you been? or did my feed fail for the last ?? months?

    1. Busy, busy. Life in lockdown is much more amenable to blogging ...