August 25, 2019
J.M Keynes famously noted that “The market can remain irrational much longer than I can remain solvent” and the notion of bubbles and ‘irrational exuberance’ is built in to much observation and commentary on markets, leading to embedded positions of perma bulls or, more usually, perma bears. Both will have their moment in the spotlight, but such polarity is of little practical help to investors. The idea of Market Thinking therefore is to be more pragmatic, it posits that the markets are in fact rational, at any time reflecting the mean or median of a normally distributed set of risk and return expectations from a mix of market participants. The fact that these participants can vary in size and influence is what makes the prediction of overall market behaviour so difficult, but observing the internal workings of markets, analysing and understanding the key players and recognising that the narrative that drives markets in the short term is always most powerful at turning points are helpful disciplines for investors.
Understanding market participants also means recognising that the key role of central bank policy is not so much setting the cost of borrowing for the economy as a whole, as in setting the price and availability of leverage for financial markets. J.M Keynes made his comment about irrational markets having lost money in the currency markets in 1920 when the $ refused to rise and European currencies refused to fall in line with his fundamental economic view, and the fact that he was ten times leveraged essentially wiped him out. Today, currency markets are the biggest market in the world, utilising enormous amounts of leverage and as a result even small shifts in the relative price and availability of leverage can dominate so called fundamentals, making liquidity an even more important driver to short term moves in exchange rates than it was back in Keynes’ day. So too with commodities, while ultimately driven by supply and demand, shifts in margin credit tend to be far more important to understanding market behaviour.
Market Thinking generally regards these markets as ‘noise trades’ since they are dominated by leveraged short term traders who aim to buy low and sell only modestly higher. In FX circles ‘a big figure’ move is actually the second decimal place, such that an extremely profitable move for a trader would be barely noticeable to an underlying economic business. Similarly the day to day business in commodity markets, which, while far less leveraged than FX, are still very dependent on margin, is usually not meaningful to the real world. In order to sell to the next person, noise traders need a powerful story, or narrative, based on economic fundamentals and the more people buy into the narrative, the more a trend develops. This tends to mean that the narrative energy to get the next buyer ‘in’ and the noise trader ‘out’ has to become increasingly higher, or ‘noisy’ such that the narrative becomes loudest and most compelling right before a turning point. Much of these behaviours are covered in the relatively new discipline of behavioural finance, but the behaviours themselves have been around far longer. In the same way bubbles can be fuelled by easy credit, so distressed sellers or forced buyers are usually, though not always, associated with deleveraging and are by definition price takers. Accepting a price meaningfully higher or lower than previously available is not irrational, for them.
This is an important part of the discipline of Market Thinking, for the next person up in the chain from the leveraged trader is the, usually unleveraged, asset allocator thinking of hedging his currency exposure or shifting his commodity allocation and the noise trader will do their level best to pass the parcel on at a profit. If they fail, then the process quickly reverses and the narrative will flip 180 degrees; the fundamentals that contradicted the previous narrative will now be promoted and the traders who sold out early on the way up will now try and sell short on the way down to force out the last people in. As such, most of the time the storms from the noise trades have blown themselves out before the asset allocators feel compelled to move and can safely be ignored. However, periodically they too can become apparently ‘irrational’ and forced to buy/sell which tends to put the noise firmly into the media headlines, where ultimately it has the chance to run right through to the long term investor such that they in turn might behave in an ‘irrational’ fashion. Trying to identify, analyse and predict the sustainability of these ‘herds’ is the essence of Market Thinking.