Making sense of the nonsensical
I’m one month into writing “Making sense of the markets” when this happens: everything and anything.
Is there like a dollar sign-shaped bat signal we can use to summon Dale Roberts back? (Roberts is the original writer of this column.)
Making sense of the short-term movements in asset markets is never exactly easy. But for the last two years, forecasting most of the world’s stock markets has meant deciding which beautiful sky was the sunniest. We had it pretty good. Recent headlines, though, have proven that the outlook just got a lot cloudier.
The first thing to keep in mind when looking at the stock market’s serpentine moves over the last week is that prices really are pretty rational in the long term. Over the short-term, however—not so much. How do we justify a stock price dropping 10% or more of the price evaluation before its earnings announcement, despite meeting earnings expectations for the last three months? The lesson being, of course, that while markets are generally efficient, it can take them a while to realize that efficient pricing mechanism’s full potential.
If stock prices aren’t responding to the fundamentals, such as earnings, then why are they going down so fast? Well, it’s probably a combination of many things. And they’re probably not particularly relevant in the long run. Here are some of the plausible theories I believe are impacting investor sentiment.
- Rising interest rates make safer investments more attractive. If you can find a five-year guaranteed investment certificate (GIC) for 4.15%, suddenly those dividend stocks don’t look quite so unbeatable right?
- Rising interest rates make equity in indebted companies much less attractive. When central banks were begging for business to borrow money and throw it at the economy, no one was bothered much by huge loans used to fuel growth. It turns out that when a bigger and bigger percentage of a company’s revenues go towards paying interest, shareholders don’t get as much put in their collective pocket.
- New-age algorithmic trading combined with traditional investor panic can quickly build downward momentum that isn’t really justified by anything other than it’s physiologically really difficult to see the value of your portfolio go down.
- Investors have become more and more comfortable with borrowing money in order to invest in stocks, or to speculate on stock movements using options. This is referred to as “leverage.” And when asset prices are going up, it allows you to make money using other people’s money—which is a pretty good deal. The problem: Just as leverage can accelerate the good times, it can also hit the gas on the bad times. As lenders see asset valuations drop, they worry about defaulted loans, and they force leveraged investors to sell via a demand called a “margin call.” If the bank gets worried that you won’t be able to pay your loan, they will force you to sell the assets you currently have. Of course, the more people are forced to sell, the lower the prices go. And the cycle can quickly become supercharged.
Even with the above four points, there comes a point when an honest market commentator has to simply throw up their hands to say, “I don’t know. It’s just weird right now, and I don’t really get it.”
I admit that it’s not the sort of bold pronouncement that TV financial gurus love to make.
But what else is there to do after the following sequence of events: