FTSE To Be Ruled By Fear

The classic drivers of the stockmarket are Fear and Greed. Right now, we are in Fear mode. To be fair, last week it was FOMO – Fear Of Missing Out – as the market bounce continued.

But this was a short term reaction, not a turning point.

FTSE over the last 6 months

The sell off in March was vicious. Once investors woke up to the dangers of the pandemic, pandemonium broke loose. The hedge funds piled into to short positions as everyone else piled out. And so the market overshot and went far too low. The small rebound sine then can be characterised in three ways.

  1. Bargain hunters thinking shares look cheap – on account of them being cheaper than they were. This doesn’t necessarily make them a bargain though.
  2. Hedge funds taking profit by closing out their short positions
  3. The classic dead-cat bounce, very often seen after a large fall. Incidentally, does anyone know if a dead-cat really does bounce if dropped from a great height? We vote that the classic TV programme Mythbusters should be reprised just to test this theory.

Dear reader, please note that none of these reasons refer to the Efficient Market Hypothesis, which we have previously claimed to be bunk. Click here to read why.

We do not believe this is the bottom of the market, nor anywhere near. It seems clear that with unemployment quickly rising to 10% and many firms only carrying on as staggering survivors, it is wishful thinking topped by political sleight-of-hand to think that the economy will just restart where it left off. Thanks for giving us so much of our children’s money, Mr Sunak. Bridging the gap makes sense, but what will we find on the other side? Will this economic viaduct be like the Humber Bridge, leaving Lincolnshire full of optimism, but then finding the other end is in Hull?

The harsh reality is that we are heading for a recession. The economy will take years to return to those heady levels of 2019. All the subsidies in the chancellor’s imagination cannot create a thirst to invest and grow. Nor can it revive dead firms.

If you must play in the market, think of using 1 or 2% of your portfolio as speculative fun. Otherwise, hunker down. This will be a long haul.

The Efficient Market Hypothesis is Bunk*

What an irony! The Efficient Market Hypothesis (EMH) famously claims that the prices of all freely traded items include all known information that could affect that price. This means that it is impossible to beat the market…… as all new price movements are the result of random new information. And yet this can only be correct if there are sufficient people out there trying to buy low and sell high – ie, trying to beat the market! So the only way EMH can be true is if sufficient people do not believe in it! For more on EMH, click here.

Warren Buffet, Sage of Omaha

Within investment circles, it has become popular to claim that the fund management industry cannot beat the market – and so investors should just buy an index tracker and save some fees. Whilst it is technically true that Fund Managers incur trading costs, and so on average must perform slightly worse than the market, we believe that the market is not efficient and so there is value to be had. Nobody can dispute that Warren Buffet manages to find value in the market nearly every year.

One only has to examine some of the assumptions of EMH. The most scary is that people are rational automatons. Now I understand that some economists live in a cloistered world, but even they must admit that this assumption is there because it makes the theorising easy, rather than it being a reflection of reality. If anyone believes in “homo-rationalis”, please take a break from whatever you were planning to do today and read Kahneman and Tversky’s Prospect Theory.

Charles Mackay

Done that? Good, so now we are all agreed that people make decisions which are not wholly rational. Perhaps this was stated most clearly by Charles Mackay in his treatise about men going mad in herds.

If you are still not convinced (how can that be?) think of all the investors who make money from trend-following in financial markets. In polite circles this is called ‘Momentum Trading’, or less positively it is known as “The Bigger Fool Theory”. Sharp readers will note that neither of these epithets refer to the underlying value of the security, just the way its market price is moving in a consistent direction. EMH cannot explain market bubbles – from tulip-mania to the tech-bubble to the Great Financial Crash of 2008 to bitcoin, these crashes occurred when investors slowly realised that perhaps values were a bit toppy – and all headed for the door at the same time! If the market was truly rational, nobody would buy bitcoin at all!

And you know what, sooner or later there will be yet another financial meltdown caused by over-optimism meeting cold hard facts……… And EMH will die again!

* Henry Ford is famous – among other things such as starting a car company, and introducing mass production techniques – for saying “History is Bunk”. We don’t agree with that, preferring George Santayana’s “Those who ignore history are condemned to repeat it.”