Market Noise

Is this the first episode of 2016?

We define episodes as phases where emotion drives asset prices. It is a name that has come in for criticism: some think it has associations with mental disorder; others think of TV shows. It doesn’t score well in marketing focus groups.

But we think it is an apt description of what periodically happens in markets, or at least the best we have. Even the associations are somehow fitting: human psychology is involved, and like an episode of a TV show, markets tend to focus intently on one thing for a short time and then discard it. Here is a picture of 2015 in episodes.

Figure 1: 2015: A year in episodes

You’ll note that these episodes often have fundamental origins. They seem so important at the time. But- in a diversified basket of equities – by the end of 2015 you were pretty much back where you started.

Which brings us to the first full trading week of 2016. It’s fair to say that it has been eventful. Here are the ‘year to date’ returns as of yesterday evening.

Figure 2: ‘Year to date’ returns

What is the fundamental origin today? Most commentators agree that China has something to do with it, but it has taken a while for a clear story to develop. Some pointed to a disappointing PMI number, others emphasised intervention in the onshore Chinese equity market and the role of ‘circuit breakers,’ more recently the devaluation of the Renminbi has emerged as the main culprit.

Figure 3: Does this justify a 7% fall in German equities?

We have written quite extensively on Chinese fundamentals with the conclusion that there are indeed very real risks; I won’t repeat those points here. The question we need to ask ourselves as investors is how much of this risk was already in the price, and whether the developments of the last four days justify what we have seen in equity markets. Might emotion again be playing a role?

Like Tolstoy’s families, each episode is unhappy in its own way. However they do share some common characteristics. Can we see any of those in evidence today?

Rapid price action

In the face of moves like those we have seen in the last couple of days, there is huge temptation to act now and ask questions later. The speed itself induces panic, and is intensified when we do. When an extra level of stress is added to the mix: like ‘circuit breakers’ incentivising us to act quickly, we are even more likely to avoid considered judgement; there is simply not enough time.

Focus on a single story

When we are in an episode, it can seem like it is all anyone can talk about. There were periods last year in which all that mattered was US unemployment and how it would impact the Federal Reserve. This week it is all about China.

The problem with this type of narrow focus is that we over-simplify our views of the future and lose sight of the true range of other factors that can impact asset returns. Like a TV viewer on a boxset binge we miss out on everything else that is going on in the world.


A further sign of episodic behaviour, and one that is related to the obsessive focus on one thing, is where there is evidence of contagion. Chinese risks are deeply challenging to analyse in their own right, how much harder is it to assess the implications of these risks in other markets? Is it right that European equity markets should all fall by similar amounts because of the actions of Chinese policy makers? Perhaps, but we find that in many cases, correlated declines of this type are less likely when the market is being considered about the pricing of assets.

Recent price action seems particularly telling in this regard. It is not news to anyone that the path of least resistance looks likely to be continued Chinese currency devaluation, nor is slowing manufacturing or trade a new development. What is new is the nature of price action in the onshore Chinese market and this seems to have played a role in spooking investors.

Yet, as I noted last April, one shouldn’t forget the fact that the onshore Chinese equity market is highly idiosyncratic. It can do some odd things, looks expensive, and, as we have seen over the last couple of days, the Chinese authorities are more than prepared to intervene. None of these forces should necessarily impact more open markets in the rest of the world.

Other characteristics of episodes

There are other signs that are common episodes. Yesterday, Jenny wrote about the odd things that can happen around year end. Might investor perceptions be coloured by the start of a new reporting year? Could less liquid markets over holiday periods heighten unusual price action? It is very hard to answer these questions and the best we can do is make sure that our own decision making is truly objective.

So, is it an episode or not?

Recent price action certainly seems to share the characteristics of past episodes. But here is the rub; just because people are panicking doesn’t mean they are wrong. The deeply unsatisfying answer is that we ultimately need to be in a position to trust our own judgement and avoid being swayed by the crowd.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.