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23 January 2013

Confidence in Equity Markets May Be Misplaced

Equity markets have enjoyed a resurgence in the New Year. But the investor confidence fueling that bounce is based on what has gotten us here rather than on the likelihood of future performance.

I spent several hours over the past 2 days reviewing the +100 financial/news/general interest websites I suspect most of you also frequent.  My purpose: to offer up a succinct explanation for the strong start to the year for U.S. stocks and the seemingly robust embrace of the same by sources of capital.  For the sake of time efficiency, here is that essential narrative:

·         Congress will kick the can down the road on lifting the Federal Debt Limit, offering the White House a short term extension and the promise of another round of budget debates in the future.  The White House signaled it will go along.  Headline risk adverted.                                                       

·         U.S. equity markets are, for the first time since the Financial Crisis, acting as if a traditional economic recovery is underway.  The old sector playbook, which many grizzled veterans of the industry had thought lost in the fire of the past few years, is alive and well.  Large cap financials, Materials, Energy and Consumer Discretionary names are beating the market in the New Year.  Those old enough to remember 1991 – 1994 and 2003 – 2005 will feel the sentimental tug of the “Good old days” in this performance. 

·         If you think of the CBOE VIX Index as a “Confidence” indicator rather than its customary moniker of “Fear Index,” then markets are indeed quite sure of themselves at the moment.  The long-term average of the VIX is 20, with a standard deviation of 6.  A reading of 12-13, which is where we are now, only occurs about a third of the time, based on the past 30 years.  And this is one of them.  Aiding and abetting the feeling of complacency/confidence is the notion that the Eurozone may not be in great shape economically, but the crisis afforded policymakers the chance to lay the groundwork for a sustainable monetary union.

·         You could add several factors to this list – better Initial claims data in the U.S., for example.  Or corporate earnings that may not impress, but are not bad enough to dramatically miss estimates. 

·         On the money flow side, the daily data for exchange traded funds (ETFs) is similarly heartwarming.  For the year to date through last Friday, U.S. listed ETFs had added $21.9 billion to their assets under management from fresh inflows.  Virtually all of it -- $21.4 billion -- went into equity funds.  Domestic markets got about a third of that total ($7.7 billion), and non-U.S. focused funds received the balance.  Fixed income funds, the darling of asset allocators over the past 5 years, are actually down $308 million YTD in terms of money flows out of U.S. listed ETFs. We only have good data from the Investment Company Institute for the first week of the year in terms of mutual fund flows -- and those were positive for U.S. stocks to the tune of $8.0 billion -- so we’ll have to wait a while to see if the ETF flows spill over into those products.  But the equity/fixed income split for ETFs does seem to bode well.

Of course, as I culled through the scores of new sources to assemble this picture, I did run across a few other items that could also support the current ever-higher market trend.  Consider these two:

·         Donald Yeomans, one of our nation’s foremost “Asteroid hunters,” has been out and about in the New Year with a bit of bullish news.  Mr. Yeomans, whose day job is at NASA’s Jet Propulsion Lab, was quoted in Scientific American online as saying, “We can say with a very good deal of certainty that no asteroid or comet large enough to threaten life as we know it will hit Earth in the next 100 years.” So despite the millions of asteroids and comets in our solar system, it appears we are all good.

·         From Smithsonian Science, news that orangutans are learning to use iPads.  It turns out that these large primates are essentially loners, so grouping them together doesn’t do much to keep them engaged with the world around them.  Zookeepers have found that they love several of the apps available on the iPad, and the pictures related to the story with orangutans touching and swiping the tablets are truly sweet.  But in a world where everyone is wondering about the future of Apple, perhaps the news of a new end market helped maintain a bullish (ape-ish?) tone to U.S. stocks.

Fun headlines aside, the central question investors and traders need to face through late January is essentially this: “What’s next?”  Everything I have outlined above – the money flows, the lack of a harmful near-term deadline in Washington, the Eurozone, even the asteroids and apes – is well known …  which means that it might make you feel comfortable, but it won’t make you much money.  All these points are familiar….  Appreciated…. Understood.

To assess why this point is so dangerous, we have to take a quick trip to the world of college dating and a behavioral psychology study published back in 2007 by Horton, Frost and Ariely in theJournal of Personality and Social Psychology.  The authors had groups of students review the profiles of people they might be interested in dating.  Each profile was essentially a list of “Facts” about the prospective boyfriend-girlfriend.  What the researchers found was that the subjects involved tended to start off “Liking” many prospects, but then as more facts were added to the description, those positive feelings cooled.  The study’s authors quoted Ben Franklin in their conclusion: “Fish and visitors have something in common: both begin to stink after 3 days.”  Or, in more colloquial terms, familiarity does breed contempt.  And psychologists can measure the tipping point from initial interest to final revulsion with alarming precision.

To tie this back to market behavior and price action, investors need to be concerned that equity markets think they have it all figured out.  Once you know a story/person/whatever, the Horton/Frost/Ariely study shows what happens next: It starts to get uninteresting and unappealing.  You wonder if you are missing out on something better. This is not to say that bullish investors have it wrong – just that a positive argument for stocks based on what’s taken us here is wrong.  Capital markets are always and everywhere a discounting mechanism of future events, so any positive view must be grounded in better-than-expected fundamentals. 

And as a final thought, consider that the overarching story of capital markets globally over the past 5 years has but one key fact: Central banks have unlimited capital and, if they want to use it, risk assets will increase in value as a result.  What will “Better than expected fundamentals” do to the easy-money policies of the Federal Reserve and the European Central Bank over the balance of 2013?  Now THAT is the question here. 

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