Thursday, January 21, 2016

Sentiment-driven market behavior - feedback or snap-back?

I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell…. So how much should we worry? This is where economics… gives the dreaded two-handed answer. If it becomes clear… that fundamentals are in fact not so bad, stock prices will recover…. [But] the stock market slump… can become self-fulfilling…. Hope for the first… worry about the second.
- Olivier Blanchard  on the current markets 

Call it animal spirits, confidence problems, sunspots, self-fulfilling prophecies, sentiment, herding, noise traders, risk-on/risk-off, or multiple near-rational equilibrium, the markets are not following the fundamental news. Economist have a hard time when market move and there is not a clear link to fundamentals. The story that links fundamentals with the price action is often a complex form of expectations and game theory. Economist do not have a good or consistent name for this behavior of prices unrelated to news. The market may be turning because there is a change in expectations of fundamentals, but more importantly, there is a change in sentiment and  markets are having a crisis of confidence. 

We express this divergence in behavior as a difference between exogenous versus endogenous risk. The endogenous risk or the risk from trading and price action is driving the markets. The exogenous risks form change in fundamentals have not been a critical driver of prices. This is a time when systematic trading based on price should be very effective. Don't focus on the fundamentals, but follow the trend and price action. The market may be herding for a number of reasons. It could be a high level of uncertainty. There could be a new assessment in expectations. The reason is not always important. It is rational to follow the price action during these periods of transition. 

There could be a market snap-back from this decline. Generally, there are a lot of price snap-backs. Markets are usually mean-reverting or convergent, but there are times when there is a change in confidence such that mean-fleeing or divergence in markets is the dominant theme. This seems to be the current state. In this environment the price decline can cause a negative feedback loop and force business confidence lower. The markets will be in real trouble if that happens. 

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