Narratives and momentum - another source of trends

 

We read stories in the newspapers. Most investors are new junkies. They are constantly reading the news and looking for new information to support their thinking or developing new ideas. I am not saying this is a good idea. It is just a fact. Even if someone uses a model, there is still the desire for news validation. An understudied area of research is narrative economics which was developed by Shiller. Markets are often driven by stories or narratives which can lead to excesses. 

An interesting study has focused on narrative momentum or the fact that investors often under-react to news narrative based on the intensity of news reports. Simply put, investors do not respond quickly to rising narrative intensity. You can gain an edge by buying stocks that have an increase in news intensity. See Narrative Momentum. This would be a failure of the efficient market hypothesis, but it makes sense. 

There is an increase in the interest of stock based on narrative intensity. If there is good buzz about a stock will start to rise, but there is a time lag between the increase in the narrative and the reaction in price. It takes time for the narrative to move through the investment community and create enough reaction to drive the price higher. Investors need validation. They take time to react.

If this is the case, there trend-follower who does not follow the news but only prices may have an edge. When the trend-follower see prices increase, he will be a buyer and not look for supporting news. The trend could be driven by a special narrative, but that does not matter. Only the movement in prices matter. These trends exists because the there is a slow reaction to news, but you do not need to follow the news to make the trade.  

End of summer and investors are satisfied

The summer is not officially over, but Labor Day usually marks the end. Schools start and vacations are over. It is looks like we have had a good summer with the Fed likely to lower rates, inflation manageable, and still no recession. The markets seem to have rationalized albeit it is still a large cap world. Small caps have done well this summer even with a give-back in August. The Mega caps in information technology and communications eaves have started to rationalize although they still dominate the markets. Growth stocks have slowed their ascent, but there is a rotation to low volatility and high dividend stocks. Bonds have done well this summer. Overall, the markets are preparing for the Fed cuts, assuming inflation has been tamed, and see continued potential gains but with a focus on getting more defensive. 

It was a good summer, now we must prepare for fall and winter. 

Some basic rules for financial regulation

  

From an old article in the Institutional investors by John Liew of AQR, there is a good list of what government regulation should and should not do with respect to finance. I agree with this list and would be happy to add to it, if there is something missing. 

• The government should recognize that bubbles can happen. It is rare, but the cost of a bubble is high and should be addressed prior to the peak. 

• The government should not subsidize or penalize some activities over others. Picking winners and losers should not be the role of the government even if other country may have a different view.
• The government should not promise to eliminate the downside. Capitalism is about winning and losing.
• The government should encourage disciplining mechanisms like short-selling (and conversely, it shouldn’t ban or penalize them). Markets need short-seller to keep the markets honest.
• The government should encourage, not tax, liquidity provision. Liquidity is critical for the pricing of markets and regulation to reduce it will have strong negative effects. 
• The government should punish true fraud harshly. Fraud creates a lack of trust. Trust is critical for market success.
• The government should have consistent laws consistently applied (for example, when it comes to bankruptcy). Consistency is critical if long-term investment decisions are to be made.

• The government and self-regulatory bodies should encourage consistent and reasonable accounting. Accounting is the lifeblood of market information.
• The government should encourage that financial institutions mark more things to market.  Book value accounting masks mistakes.

 

Market efficiency and two schools of thought

 

Tests of market efficiency are two tests. One, a test of efficiency, and two, a test of the model used. This is leads to the great divide in finance. There is one school, the behavioralist view, which states that a failure of a model is based on irrationality. There are mistakes caused by a deviation from rationality, behavioral biases. The other school states that markets are rational, rather it is the model that is the problem. If we have a model failure it is because we have not modeled risk properly. Any anomaly is based on our inability to correctly measure risk. Hence, there are two camps or schools of thought, the risk pricing camp and the behavioral camp. 

Many of the factors that are studied in finance cane be structured around these two camps. The value factor can be thought of as price for value risk or it can be thought of as a behavioral issue. The same can be said for something like the momentum factor. The challenge for the efficient markets hypothesis is whether there is a good risk story for market anomalies or whether it is necessary to fall back on a behavioral story.

Can markets be irrational or inefficient? Yes, it is possible, but it is rarer than often thought and the first view should be that markets are rational but prices are not modeled correctly. Anomalies exist relative to our core theory and modeling. Markets are reasonably efficient, but this is not the same as perfect efficient. Market usually use all information, but the pricing of this information may not be properly models which offers opportunities for investors. Efficiency is a theory which must be tested constantly. The theory is based on the assumption that markets are competitive, and it is hard to make money in a competitive marketplace.