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Article 173
SFDRInvestors who ascribe human thought processes to price movements and levels are likely to be surprised by ‘impossible’ scenarios.
We like to express the fundamental divergence between investors’ rationale and financial markets’ rationale from the angle of probabilities: investors think in terms of conditional probability whilst financial markets think in terms of simple probability. To illustrate this, consider the following chart:
The two lines represent equity indices of equivalent volatility. If you ask investors which has the highest expected return, a majority would pick the green line, due to conditional probability. Looking at the blue line, you might assume that the probability of a 5% rise – given that the price is in overbought territory – is well below that of the green line, which looks in recovery mode and not at all in overbought territory. “Time for the Green to play catch-up!”, they might say.
This bias of perception is really common among investors but it is a misleading bias because market returns are purely stochastic. The notion of conditional probability does not apply. Actually, the blue line is the S&P500 Info Tech and the green line is European Telecoms. The S&P500 Info Tech has just recorded 15 positive days in a row: a historical first. What was the probability of that occurring? Close to zero. But it happened!
The Chart 2 below is the correlation for European sectors of their 3-month performance, their EPS momentum (left chart) and their expected EPS growth (right chart). The message is the same: there is no coherence. Yet investors, applying mental processes, tend to find a relationship between the behaviour of asset prices and what they can identify around them.
When a stock price soars vertically, investors estimate that there is the risk of a price correction. When one sector outperforms another, they try to find a good reason for that (higher quality, higher growth, cheaper, etc). That is a normal human reaction. But the reality, as shown before, is completely different. Financial asset prices do not necessarily react in what humans might consider a ‘rational’ way.
This point reminds us of how little we really know about economics and finance. Claudio Bario, Head of Economic Research at the Bank of International Settlements, was asked recently by a journalist: “Why do we have low inflation?” He answered: “We do not fully understand this.”
The recent behaviour of financial markets has been really puzzling because extreme events have occurred. Aside from the amazing run of the S&P 500 Info Tech and consider the 2-year German government bond yield that declined below -0.95%.
How is that possible? We want to say “We do not fully understand this” but this is a market price. When things happen that should not have happened, we have to be open-minded and accept that previous assumptions and/or theories can be wrong.