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Why you can’t rely on markets to tell you anything useful

The market reaction to Donald Trump’s threat of a trade war has been muted to say the least. But that doesn’t mean anything, says John Stepek. Here’s why.

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Trump: wants to impose tariffs in "a loving way".

Donald Trump is thinking of starting a global trade war.

He also said something the other day about imposing tariffs in "a loving way". Which, however you look at it, is just weird.

Meanwhile, Gary Cohn seen as one of the few "adults" in the White House, even by those who don't like him has walked out, mainly because he couldn't convince the US president not to start a trade war.

Yet the market doesn't seem bothered.

Does it know something we don't? Should we listen to the wisdom of the crowd when it tells us not to worry?

I think you can guess my take on that.

Why the market has a tendency to run off the edge of a cliff

We'll get back to Trump and his loving tariffs in a second. First, let's examine the market reaction.

Cohn walked out on Tuesday. He's an ex-Goldman Sachs guy, so Wall Street liked him; he was one of them. On a wider basis, he was also seen as someone who had a grip on reality and also something approximating a backbone in terms of having a set of coherent beliefs that wouldn't simply flip-flop with Trump's whims.

The market didn't like it at first. Particularly as, for a brief period, it thought that Cohn had managed to talk Trump out of imposing any tariffs. But it rebounded yesterday, and now it's as though nothing's changed.

So what's it all about? For that, we have to turn to one of the many "flaws" we see in markets the fact that momentum investing works.

Momentum investing is one of several "factors" that are recognised as exceptions to the "efficient markets" rule.

Factors are anomalies that allow you to beat the market over time. In effect, they wouldn't work if human beings acted in the narrowly rational way in which theory assumes we act.

The way momentum investing works is simple in theory: you buy what keeps going up and you sell what keeps going down. (It's harder in practice, like all of these "factors", but we're just dealing with the theory today so we'll put that aside for now.)

So why does momentum investing work? Why, once a stock or a market is on a rising trajectory, is it more likely to keep rising?

Or, to bring it down to what's going on today, specifically why is the market so willing to shrug off what seems like pretty bad news in favour of sticking with the status quo?

Put simply, it's because we have selective hearing.

A mob of lazy coyotes

We don't like to change our minds. Once we find a worldview that we're comfortable with, and one that seems to work pretty well, we're loath to move away from it. So our brains immunise themselves against contradictory data and attend to stories that confirm what we already believe ("confirmation bias").

There are all sorts of reasons for this. If you find a way of looking at the world that works, then ditching it for a new worldview is risky. A disinclination to change your mind also prevents terminal analysis paralysis if you didn't have a "default" setting, then it would be hard to get anything done at all. And there's all sorts of tribal stuff too.

But you don't need to get deep into the weeds on the psychology to understand this. Put very simply: we're lazy. Changing your mind takes cognitive effort; it's hard. Most of the time, we don't like expending effort unless we need to.

Hence, we like to assume that things are going to stay the same as they were yesterday. Hence, momentum investing works, because it's based on extrapolation, which is among the most basic forms of pattern-spotting behaviour in human beings.

Problem is, no trend lasts forever. Momentum might take you over the edge of the cliff, and like Wile E Coyote on the roadrunner cartoons, you might even keep running on thin air for a while.

But eventually you realise something's changed. And from that point, it's a long way down.

Maybe it'll all be fine

Don't get me wrong maybe we'll get lucky. I can't follow Trump's decision-making process, but he does seem to flit about a lot, playing favourites. Keeping his court on their toes.

He seems to be backing away from his original idea of just slapping on steel and aluminium tariffs willy-nilly, and moving towards something that's more specifically targeted at China. We'll see when he actually signs off on the tariff policy.

And making short-term bets on political manoeuvring is a good way to lose money in any case.

But while I think we can't ignore the wider move towards de-globalisation and other inflationary policies, that's not really my point this morning. My point is more this: don't imagine that the market can tell you anything useful about all of this.

It's easy to assume that the market knows best. That the absence of a huge reaction to apparently bad news means that you must have misunderstood what's going on.

Momentum and confirmation bias mean that once the market has got a certain idea in its head, it's very hard to shake it off. And that tendency gets more pronounced the longer the trend goes on for.

At the bottom of a market no one wants to buy because they assume it'll keep going down. At the top of a market, no one wants to sell because they assume it'll keep going up.

All that you can do as an individual investor is to ignore the direction and to look at the value on offer. Right now, US stocks might be going up, but they look very expensive, regardless of what Trump pulls out of his hat next. That's reason enough to have most of your money elsewhere.

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