Think of global equity markets as a network

 We have been spending more time thinking about markets as networks or clusters. Don’t think about asset returns in isolation, but through the connections across markets and regions. Some of the latest work in this is presented in the paper, “Clustred Network Connectedness: A New Measurment Framework with Applicaitons to Global Eqiuty Markets” by Buchwalter, Diebold, and Tilmaz. 

These authors have been working on the network process for asset returns through variance decomposition of VAR models. From these models, the authors have been able to distinguish causality from and to markets across a wide set of markets. Their latest work on global equity markets seeks to address econometric issues arising from the decomposition method. This process of decomposition will provide a different narrative but will also answer questions about whether there is contagion or just co-movement across the network. The graph above shows the traditional method for forming the clustered identification. The graph below looks at the same data, accounting for groupings within the network after accounting for generalized identification.

Note that in the clustered identification, the US equity market serve as the center of netwrok behavior while the generalized idienificaiton which accoutns for correlation within groupinsg of the 16 equity markets studied, shows the high connection that is the focus of the EU cluster. Both provide interesting interpretations for how equity markets are connected. 

 

Good News - Bad News - overreaction to the bad news

There is good news and bad news that comes to the markets through new information that impacts expectations. News will have a differential impact, and investors should always be ready for it. Good news will drive prices higher, and of course, bad news will have the opposite effect, yet news will have a differential impact. Good news will usually be met with underreaction, while bad news, at the extreme, will be met with overreaction. To put it simply, the bad news forces investors to sell, and there has to be a buyer on the other side of the trade. To find the buyer, the markets will have to overreact to provide the buyer with a premium for considering the higher risk posed by the bad news. In the case of good news, there is no forced selling that requires new buyers. There will be a reaction, and there may be some extreme buying, but the buying excess is driven by a supply shortage, not by a need for a premium to induce buyers. 

Oil shocks and war - This could be different

UBS provides an interesting chart on the impact of war on oil prices. As expected, there will be a positive price shock, but it usually returns to normal after 4-5 months. Call this a fear factor. There will be some hoarding at the beginning of the war to protect inventories. Once the worst is over and the disruption is viewed as manageable, the price increase will be reversed. Yet, you cannot extrapolate from this evidence that the current situation will be normal. First, there is no reason to expect a return to normalcy. We only know that after the fact. Second, a disruption ot the Middle East is different from a war in other regions. If infrastructure is lost due to the destruction of refining capacity, there cannot be a quick adjustment. Oil can be pumped, but without refining, a "soft target" there will not be any easy way to create the end product needed by consumers. Capital expenditure for refining is costly and long-term, unlike the sinking of a tanker or the closing of a strait. The focus for any oil shock should be centered on what is happening to infrastructure. 

 

Retail investors love hard to value stiocks

 

How do retail investors behave? I wish I knew. It seems that they have an increasing impact on some markets, but where is the focus? A paper titled "The Retail Habitat" seeks to answer this question and finds that retail investors prefer to trade hard-to-value stocks. Stocks with a lot of retail trading have more intangible capital, longer-duration cash flows, and are more likely to be mispriced. So why do retail investors focus on the harder-to-value names? The authors do not fully explore this critical issue. They just identify the stocks that seem to have more retail focus. I would suggets that that retail traders focus on big bets, the lottery tickets. The lottery ticket names, of course, will be stocks that can possibly produce large gains.