The Siren’s Market Analysis: Beautiful Yet Dangerous
On January 28th, Seeds highlighted the seasonal risk rally that has occurred each of the previous six years, from February through April. Each time it had begun with a rally in equities, followed by commodities before filtering down to emerging markets. In every conversation I had with clients in the days that followed the publication of that piece, I emphasized two key points. 1) These things don’t happen in a straight line. Although the charts and graphs included in that edition gave the appearance of unidirectional moves throughout the periods in question, it isn't quite so straightforward when you’re living through it. Within those “green” periods, you have up days and you have down days. Which led directly to my second point of emphasis. 2) Although on January 28th, it was easy to possess great conviction for the view that the next three months would favor risk assets, that view, and their confidence in it, would be challenged many times before all was said and done. Which is why, this time around it was equally likely very few would benefit from it.
It wasn’t long before that conviction was put to the test, and all the warnings were quickly forgotten. From February 1st through the 11th, the S&P 500 dropped 110 points and I quickly lost my audience. To be honest, I couldn’t blame them. After all, my argument that risk assets would turn positive wasn’t supported by fundamentals, nor was I anticipating any particular adjustment to policy that would make the case. In fact, my argument was based on the recognition that nothing had changed for six years, and nothing is likely to change for some time to come.
Since market participants were in maximum bearish mode at the time, my thesis probably sounded a little silly, especially after 10 days of very poor price action right out of the gates. Here’s the thing about moments like this, where you expect prices to run in direct opposition to what the fundamentals are telling you. You have to recognize what is truly driving the anomaly. You must accept that, in the grand scheme of things, it is little more than noise. Well, noise as it relates to the underlying economics. However, the anticipated price action wasn’t completely without foundation. It would be driven by cognitive bias.
As a reminder, the definition of cognitive bias is a systematic error in judgment, meaning the errors are predictable. If markets are perfectly efficient, then it should be the case that when economic trends remain firmly in place, price action won’t experience these sporadic reversals. But they do. Every year since the crisis, no matter what was prevalent on investors’ radar, risk rallied between February and April, and every year that price action was unexpected, and, with the benefit of hindsight, out of step with the underlying fundamentals.
This time would be no different. In a conversation with a long-only emerging market manager with $2.5 billion under his direction, I readily acknowledged that it made no sense whatsoever to ramp up risk, from a fundamental perspective. However, that had been the case in every other year since the crisis. Yet it turned out to be a good trade each time, and for a reason that could be explained.
Fast forward to today, a little over a month since the S&P bottomed out. Just as they have in previous years, market participants are once again creating macroeconomic narratives to fit the price action. But, of course, it’s a fools game. Nothing has fundamentally changed since February 11th. Neither negative rates in Japan, nor the “surprisingly” dovish Fed has consequentially altered the economic landscape, but it will not stop people from pretending it has so as to make sense of the price action. This is all part of the phenomenon driven by cognitive bias.
In those conversations back in late January, I warned against getting sucked into the narrative fallacies that would inevitably accompany the risk rally, should it occur. The very narratives that we are knee deep in at this very moment. The analysts proclaiming the bottom in commodity prices, the end of the US Dollar strength and the turn of fortune for emerging markets. (Admittedly, that last one is still in its infancy.) I don’t buy any of it. The only evidence in favor of it is the price action itself. In other words, the reason commodities have bottomed is that commodity prices have bounced off the lows.
These are the siren songs of the analysts, economists and talking heads. Whether you fill your ears with wax to avoid the seduction of those very compelling narratives or tie yourself to the mast to avoid acting on them, action should be taken. For no matter how beautifully woven the story, it is still a work of fiction. Just as it was in each of the previous 6 years. When I called attention to the likelihood of a rally in risk assets, I had no idea who would play the starring role in the plot lines that would develop to explain the price action. All I knew was that the human brain doesn’t handle uncertainty well. When something unexpected occurs, like a powerful and pervasive risk rally when all the evidence argues against it, our brains immediately set about the task of crafting a story that allows it to makes sense within the context of everything we firmly believe about our world. Rather than accept that recent price action is merely a function of fatigue and predictable behavior patterns, we’d prefer to flip the cause and effect on its head, so price action explains macroeconomic fundamentals, rather than the other way around. My advice is, ride the wave, but beware the siren’s song that will have you crashing into the rocks if you take it too far.
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
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