Markets – Sale of the Century or Bargain Hunt?
In order to understand why markets have been so jittery recently – given that there hasn’t really been any sudden and significant change of direction in financial newsflow – then you first need to look at how they operate.
I remember watching a Top Gear episode where they were testing an intelligent car, ie that drives and parks itself. Well, would you sit with your hands on your lap as it races round the M25 at 70mph? No, probably, like me, I guess most would still have your hands firmly on the steering wheel. Even though this action could, in fact, cause the car not to perform in the most efficient way possible.
And so here’s the nub of the problem with market volatility. On the one hand we have all the highly sophisticated computerized systems which can instantly analyze every bit of financial data (ie both announcements and stock and general market activity) and – using strict mathematical or fundamental analytical methods – can convert this information into an immediate trade execution. For students of economics, this – in theory – should be a perfect example then of the Efficient Market Hypothesis which states that, at any given time and in a liquid market, security prices fully reflect all available information. Brilliant – a utopian world with no more volatility except in reaction to seismic one off events.
And the reason it doesn’t work is the same as why we don’t (yet) trust the intelligent car – ie human intervention. Despite all that technology most decision-making is still done by human beings and is therefore subject to both human error and human emotion.
Why the sudden spike in volatility?
Volatility in markets (aka short term rises and falls) has spiked up in the last couple of months, but is still well below historic levels (in 1987, for example, markets fell over 20% in one day). To a large extent the falls have been a delayed knee-jerk reaction (aka human error) to a slow accumulation of less positive (as opposed to absolutely negative) newsflow. Expectations were that a combination of exceptionally low interest rates and a veritable tsunami of cash stimuli by the main central banks, would reignite growth and thus justify premium valuations.
This partly explains the limited response to the increasing numbers of profit warnings over both 2015 as a whole (the highest since 2008) and Q4 last year (highest since 2009). Adding fuel to the fire, just out a particularly gloomy report by the influential business consultants McKinsey entitled The new global competition for corporate profits which concludes that trend company profit growth is going to slow considerably over the next decade.
Are we there yet?
Probably not. Unlike the recent floods, key market technical support levels have, so far, only been temporarily breached, and current valuations are still well above technically oversold levels. I say probably because one cannot rule out some form of concerted stimulus (at the moment purely verbal!) by central policymakers.
I have commented previously on the propensity of markets to overshoot in both directions and no doubt 2016 will be no different. A key factor this year is that, given the relatively low levels of GDP and (most) corporate earnings growth expectations, then even relatively small deviations in either direction will likely be accompanied by an excessive market reaction.
So, plenty of opportunities for speculators and day traders who will no doubt continue to distract attention from the real direction of earnings growth. We will most likely have to wait until the second half of this year for a clearer assessment, but the good news is that it is only the lower level of growth markets need to adjust to, not a complete reversal. There are still plenty of areas doing very nicely thank you, it’s just that the premium accorded has, in many cases, simply been too high.
By Michael Lally, director at Thesis Asset Management