Advertisement
Features

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.

180308-trump-b
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.

Advertisement - Article continues below

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.

Advertisement
Advertisement - Article continues below

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.

Advertisement - Article continues below

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?

Advertisement - Article continues below

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").

Advertisement
Advertisement - Article continues below

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.

Advertisement - Article continues below

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.

Advertisement - Article continues below

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.

Advertisement
Advertisement

Recommended

How long can the good times roll?
Economy

How long can the good times roll?

Despite all the doom and gloom that has dominated our headlines for most of 2019, Britain and most of the rest of the developing world is currently en…
19 Dec 2019
The British equity market is shrinking
Stockmarkets

The British equity market is shrinking

British startups are abandoning public stockmarkets and turning to deep-pocketed Silicon Valley venture capitalists for their investment needs.
8 Nov 2019
If companies have too much power, we need more competition, not higher taxes
US Economy

If companies have too much power, we need more competition, not higher taxes

Free-market capitalism is breaking down and that is going to lead to higher taxes down the line. John Stepek explains why that matters for investors.
11 Aug 2020
James Montier: valuations are way too high
Investment gurus

James Montier: valuations are way too high

The market is completely discounting the risk to the economy and operating as if there is nothing to worry about, pricing in a V-shaped recovery, says…
10 Aug 2020

Most Popular

Eagle Lightweight GT: the reincarnation of the E-type Jag
Toys and gadgets

Eagle Lightweight GT: the reincarnation of the E-type Jag

Jaguar’s classic E-type sports car has been reinvented for the modern age. The result – the Eagle Lightweight GT – is a thing of beauty.
7 Aug 2020
Should you take advantage of the UK’s new breed of domestic holidaymakers?
Buy to let

Should you take advantage of the UK’s new breed of domestic holidaymakers?

With Britons choosing to holiday in the UK this year, the owners of the country’s holiday cottages are cleaning up. Should you buy in, too? Merryn? So…
10 Aug 2020
The pound has been trending higher against the dollar – will it last?
Sponsored

The pound has been trending higher against the dollar – will it last?

Sterling has been rising against the dollar. Dominic Frisby sets his trend lines in the charts to see where the pound is heading next.
10 Aug 2020