Last Friday, I sent out a brief message wherein I suggested that the market’s initial reaction to the poor employment data had been “misguided.” Allow me to explain what I mean by that.
For some time now, the “will they / won’t they” that the market has been grappling with has been whether or not the Fed will raise short term rates. With each and every release of economic data, those expectations are adjusted, and its derivative effects extrapolated out. It is in those derivative effects and the question as to how far out they should be extrapolated that uncertainty arises.
In the most recent episode, the jobs data implied weakness for the US economy. That weakness, an expectation derived from the data, reduces expectations for sales, on a corporate, country and regional basis. When sales go down, typically earnings and valuations do too. Sales are a reflection of demand, which is also likely to be soft. Given that the Federal Reserve has two mandates, inflation and growth, the market rightly makes an adjustment to their expectations regarding Fed policy. In other words, they reduce the probability of higher rates in the near future. If the market is pricing in a rate hike prior to the jobs data, a reduction in the expectation of a hike has the same impact as a cut. A cut is designed to spur growth. Growth is good for risk assets.
That is how an economic data release that implies bad things for growth, and by extension, for risk assets, can be interpreted as actually being good for them. This is the reason it is so difficult to trade the short term reaction to data releases. Poor jobs data could drive risk assets lower, because poor growth is bad. On the other hand, they could rally, because poor growth spurs action that will lead to demand for those same assets. Both outcomes make perfect sense. Why then did I call the reaction “misguided”?
The only reason both market reactions can make sense is if monetary policy is effective. I don’t believe it is. The reaction function known as the transmission mechanism, is broken. The three key decision makers (CEOs, mega-wealthy and pension fund managers) who control the overwhelming majority of capital in the world have been exhibiting incredibly risk averse behaviors for years. So risk averse that even negative interest rates haven’t incentivized them to take on risk and invest in the real economy. If lower rates won’t spur growth, then the expectation that risk assets should rally on the back of poor economic data is misguided.
Investing vs Gambling There is a difference between gambling and investing, and it comes down to a combination of the odds of success and the certainty regarding those odds. To boost both in our favor, we gather intelligence searching for correlations and causations so that we may predict future outcomes based on what has already occurred.
When you advise a recent college graduate to invest their savings in a diversified portfolio of equities, you feel fairly certain that over time, that portfolio will grow in value. Even if you don’t know by how much it will increase, you feel confident that the value will be greater than it is today. You believe that, because historically it has been the case. Would you give the same advice if they said they’d need the money back in the next seven days? Of course not, but why? Well, the shorter the horizon, the more random the returns. The risk versus reward for the exact same investment vehicle is different. The longer the investment horizon, the greater your conviction. Therefore, the longer the investment horizon, the more we think of it as an investment as opposed to a gamble.
This doesn’t apply to every asset. Would you give the same college graduate that same advice about oil, South African Rand, or even gold? Perhaps you would, but first you would want to gather data regarding those assets, to be sure that you had similar expectations. It’s possible, however, that even if the data suggests that all of those assets would make even better long term investments, you would be less inclined to suggest that they put their savings into the South African Rand instead of the S&P 500. The question is, why would you hesitate? The answer is, cognitive bias.
GBP Thoughts As I wrote in Seeds 16-19, the moments when you are supposed to be at maximum risk also tend to be when you are least confident in your view. If, for instance, you are bearish EURGBP based on your fundamental view, ideally you will have clear expectations for its trajectory along with a well defined range around it. At the top of the band, the risk / reward is more favorable than at any other time. After all, you are closest to your stop-loss and furthest from the take-profit. Well, here we are, near the top of the band (see chart). It’s scary to sell here though. I mean, what if it breaks through the topside on the back of a “Leave” vote? That is the risk. Could it gap? Absolutely. Here’s the thing, though. Right now, today, can you say for certain whether GBP will strengthen or weaken on that news? If the argument is that it will weaken, because it represents uncertainty, given that EUR is also affected by the vote, couldn’t the same be said for EUR? IF, you are bullish GBP, particularly versus EUR, based on fundamentals, this is your opportunity to express that view. Yes, there is risk, but given the spot entry level, not to mention an implied volatility market that is incredibly high, along with skew that is at extremes, there are terrific opportunities for expressing that view with defined downside that makes it even more favorable from a risk / reward perspective.
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 and Behavioral Investing in the College of Engineering 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.
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. 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.
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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