One of the most interesting trends of the last decade is the rise of behavioural psychology. Behavioural finance – one of its sub-disciplines – has risen out of the debris of statistical investment modelling, which performed so poorly at the time of the Global Financial Crisis (GFC). Critics of the statistical approach (which is also known as Modern Portfolio Theory) have pointed out that risks can be underestimated if they have never occurred before and thus are not in the data – such as the sub-prime mortgage security meltdown.
Behavioural finance also notes, crucially, that humans are risk-averse and are thus substantially more likely on average to believe a negative forecast than a positive one. This is part of our evolution, as warnings based on past hazards are more adaptive than encouragements based on future optimism. Daniel Kahneman won a Nobel Prize for Economics for his research on this topic, laid out for the lay reader in his book “Thinking Fast and Slow”.
When applied to investment strategy, psychology points to a set of human biases which distort the decision-making process and lead to mistakes, or at best, to missed opportunities. A clear example of how this happens in practice has just played out in global equity markets in December and January. To recap, having reached an all-time record high at the end of last September, the US share market embarked on three months of concentrated weakness, culminating in a Christmas Eve crescendo of selling that left the S&P 500 Index down -19.7% from its peak. In place of the traditional ‘Santa Claus rally’, which more often than not lifts markets in the final fortnight of the year, investors were confronted with the worst period for stocks since 2011 and the worst December since 1931.
This dramatic reversal in the equity market’s direction, coupled with its surprising timing, created a drama that contemporary 24-hour business news coverage then amplified. Commentators and some analysts entered a feedback-loop where the market correction was ‘explained’ as an indication of much higher recession risk than had previously been appreciated. The culprit in this narrative, at least according to one influential commentator currently occupying the White House, must be the US Federal Reserve (the Fed) and its Chairman, Jerome Powell, who were wilfully tightening credit conditions on a slowing domestic economy and thus choking the long bull market. The 2019 year opened with an extraordinary degree of pessimism and caution in the air.
The chart shows surveyed investor confidence at depths unseen even during the GFC in 2008 or the Eurozone debt crisis of 2012:
How, then, to explain what the US and most other global equity markets actually delivered to investors in January – namely, one of the strongest and broadest market rallies in history? Behavioural finance would answer that bearish commentators fell victim to the ‘availability bias’. This bias, simply stated, overestimates the predictive power of recent information held in the memory. For example, workplace safety planning adjusts for the fact that workers who have never had an accident operating dangerous machinery systematically underestimate the probability of an accident in the future (‘false sense of security’). In the opposite version, children from war zones overestimate the risk of physical danger and hostile strangers when resettled in peaceful countries (‘false sense of anxiety’).
So, after a year of broadly volatile and negative asset returns in 2018, many investors have become extremely anxious and pessimistic, and have been taken by surprise by the strength of the 2019 market rebound. Human psychology tends to rationalize, so now the dominant narrative is that the rebound must be temporary or baseless, and will fade. We think the risk is rather that it will continue and may even accelerate. JP Morgan has noted that many global measures of assets are pricing in slower economic growth than the actual current pace. Cyclically-oriented gauges like the S&P 500, European autos, Chinese equities, Japan’s Topix, emerging market equities and commodities “still seem to trade as if global growth were running about a percentage point weaker than its actual current pace”. So 2018 began with too much market optimism, but ended with too much fear. Weakness in equities undermined central bank confidence.
The Fed last week pivoted away from their prior prudent course of lifting interest rates regularly, to a slightly panicked course of announcing rate hikes are effectively now “on hold”. Global cross-currents were given as their chief rationale. The Fed’s dovish shift and its flexibility on rates and its balance sheet is akin to its 2016 interest rate pause. The result of extending stimulus (because US growth is still being stimulated by both monetary and fiscal policy) when the economy itself is still robust was a rally in shares right through 2017.
We feel, on the balance of probabilities, another rally is likely to develop in the first half of 2019. US corporate earnings growth is supportive and though considerably lower than last year’s, still looks on track to be around 6% in 2019. While the US market still dominates the global equity index, the other main economic regions have considerable scope for a catch-up, and better sentiment could well lift the 2019 return from international equities and other growth assets, even if the US turns in a flat performance. Rising interest rates were the main threat to shares, and this threat has been neutered, for now.
Value has emerged for the first time in 18 months – we buy in
The drop in market valuations experienced in late 2018 indicates many investors have already adjusted to diminished (but not negative or contracting) profit expectations. The final months of last year, afflicted by a huge quotient of negative headlines from the USA and UK, induced a sceptical and highly-pessimistic mindset, but profitability is still present in most industries. We have been waiting for 18 months to allocate away from our above-average level of cash, once some value emerged in the growth asset classes of equities and listed real assets. Although we would have preferred a cheaper entry point, we believe that the 20% peak-to-trough decline in some major global markets from September to December was probably the best opportunity we are likely to see this year. The ‘saw-tooth’ pattern of volatile, sideways-trending markets could continue for a few months, as issues like Brexit, China, interest rates remain unresolved, but the outlook is becoming clearer.
However, we expect uncertainty to diminish and the restoration of equity-friendly market conditions to become more widely acknowledged. The exact month this year in which this will lead to a ‘buying climax’ is impossible to predict. Therefore, we are now positioned ahead of a positive resolution to a variety of global strains and tensions, which could well unleash a final equity rally of this decade-long cycle. In anticipation, we have adopted moderate overweight positions in international equities for all funds, which we expect to hold until we see a more concrete threat set to the expansion.
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.