Butterflies & Markets: Covenant’s Weekly Synopsis

September 16, 2019

In this week’s edition:

  • Last Week Today – A summary of the most impactful news on financial markets and the economy.
  • Butterfly Effect – Sometimes large moves in the market start with the smallest of impulses.
  • Bad News – Media is as negative as it was during the Financial Crisis, causing some investors to back away from markets.
  • Behavioral Finance – A look at Cognitive Dissonance and how to make better decisions.

Last Week Today. Central banks were on the easing-train last week. China cut its banks’ reserve ratios by 50bps, freeing up $126 billion in available lending. The European Central Bank pushed its official borrowing rate further into negative territory by 0.1% to -0.5% and went back to the QE-crutch, promising to buy €20 billion per month for as long as it takes to get inflation and growth prospects back on track. The Fed is meeting this week and expected to cut rates by 0.25%. | “He said, Xi-said” saw a bit of a détente as China’s President Xi exempted 16 types of U.S. imports from tariffs and encouraged its stated-owned enterprises to purchase soybeans from US farmers. President Trump reciprocated by pushing out scheduled tariffs on Chinese imports by two weeks. | U.S. inflation data from August showed signs of life as both the Producer Price Index and Consumer Price Index rose slightly more than expected. The overall level of each remains contained with little risk of breaking out to levels that would damage the economy. | On Saturday, a coordinated attack on the world’s largest oil refinery cut global supply by 5%. Iran-backed Houthi rebels claimed responsibility for the attack, but U.S. officials suspect Iran may have played a more direct role. Oil futures immediately jumped 13%, but this morning are closer to +9% as the initial shock wore off.

For a summary of weekly, month-to-date, and year-to-date financial market performance, please click here.

Butterfly Effect. Chaos theory holds that small changes in unstable systems can have significant effects. For example, Chaos Theory holds that a butterfly flapping its wings at the right time in Brazil can cause a hurricane in the Atlantic Ocean. This “Butterfly Effect” can be applied to financial markets in which small changes at the margin can produce large changes in the prices of financial assets. We saw two such cases last week. While at the surface the equity market was rather calm, with the S&P 500 rising more than 1% and the VIX Index at a low 13.7, the internals of the market were convulsing. The types of stocks performing best over the last one-year, two-year (and in some cases longer) suddenly became the worst performers. Momentum stocks (i.e., stocks with strong upward trending prices), which had gained +23% YTD before last week, were suddenly shunned and fell -2.3% (as measured by a momentum ETF: MTUM). Value stocks, which have underperformed Growth stocks for ten years (to the chagrin of active portfolio managers everywhere) reversed and outperformed +2.4% to -0.5% for the week.

The tumult was not limited to equities, and after a period of sharply declining interest rates, fixed income investors found themselves in unfamiliar territory as rates backed up with the yield on the benchmark 10-year US Treasury rising more than 0.3% in a week. The chart below shows the upward shift of the US Treasury curve (green = curve as of Friday, yellow = curve one week prior). It’s also worth noting the flattening of the curve, which took much of the curve out of inversion (i.e., longer-maturity bonds yielding more than shorter-maturity bonds).

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Sources: Bloomberg, L.P. .and Covenant Investment Research.

What caused this sudden shift in market sentiment? It wasn’t a news event, and no one rang a bell signaling investors to sell Momentum stocks and Treasury bonds. In all likelihood, it was one or more investors independently taking risk off the table because, in their view, these types of assets were overpriced. Other investors (and investment algorithms) seeing a decline in prices followed suit and the Butterfly Effect took hold. This happens fairly regularly in markets. Sometimes they are nothing more than a sector rotation that is barely noticeable at the surface like we saw last week. Other times they are impossible to miss, such as the pricking of an asset bubble (e.g., the Dot.com and mortgage bubbles). For all of the regulation, financial markets are inherently unstable systems subject to wide price fluctuations, and last week is a good reminder of why portfolio diversification remains as crucial as ever.

 

Bad News. As the chart below illustrates, even as the stock market approaches all-time highs, investors have been running in the other direction, pulling money from equity investments and charging into bonds and money market investments. What’s remarkable about this chart is that the flows accelerated right about the time the Fed cut interest rates, directly reducing the yield on money market funds which received the highest capital flows. What were these investors thinking?

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Source: Deutsche Bank Research

The chart below offers an explanation. Day in and day out, investors are bludgeoned with negative news about the economy and financial markets. I’m not saying this is fake news per se, but often media sources report on the most sensational and fear-mongering data points to get Internet clicks and viewers to sell more advertisements. Just take a look at the chart, as they say in the media, “If it bleeds, it leads.”

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Anecdotally, I see a lot of negative news every day as I track financial markets. Currently, the negative news is outweighing the positive by a wide margin, and the chart above confirms my experience. Great Justin, but what’s your point? The point is that news headlines can move markets in the short run, but fundamentals drive financial market prices in the long term. Unfortunately, negative news, which has reached levels last seen in the Financial Crisis, is causing people to make questionable investment decisions.

Are the U.S. and global economies slowing? Yes, they are. However, the economies aren’t contracting, and the current data does not suggest either is on the cusp of doing so. This is not a call to get overly aggressive with your portfolio allocation. Instead, it’s a call to know what you own, why you own it, to calibrate your expectations based on the fundamentals, and to pay less attention to the media whose fortunes are tied to selling advertisements – an endeavor that is critical for their survival but is irrelevant to your financial interests.

 

How the Mind Works Against Successful Investing – Cognitive Dissonance

(Entry #7 in a series on Behavioral Finance)

We have concluded our section on Emotional Biases, and will now turn our attention to the other broad category of Behavioral Finance Biases called Cognitive Biases. As a reminder, the taxonomy we are following is:

  • Emotional Biases – irrational decisions based on instinct or impulse, rather than conscious calculations. Emotional Biases emerge from peoples’ personal experiences and are based on how they feel rather than how they think.
  • Cognitive Biases – systematic errors in thinking that cause us to act irrationally repeatedly. Cognitive Biases often occur because of heuristics, mental shortcuts we have developed to make decisions when time is limited.

In simple terms, Emotional Biases lead to poor decisions based on feelings, whereas Cognitive Biases produce suboptimal decisions based on faulty logic. Generally speaking, Cognitive Biases are easier to correct because the resulting errors can be illustrated as illogical. Humans are much more willing to accept they made a mistake in logic than to admit their feelings about a topic are questionable. Following author Michael Pompian’s lead, we divide Cognitive Biases into two categories: Belief Perseverance – sticking with the status quo, even as newly available information conflicts with that decision; Information Processing – assimilating data illogically.

The first Belief Perseverance bias we cover is cognitive dissonance, which serves as the psychological concept from which all other Belief Perseverance biases stem. In sum, cognitive dissonance is the mental discomfort or natural alarm someone feels when new information contradicts previously held beliefs, ideas, or values. Said differently, new information that conflicts with existing thinking makes people so mentally uncomfortable they will go to great lengths to convince themselves they are right, often through means that lead to poor decisions.

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Source: The Daily Star

This Orwellian-sounding term was coined by American social psychologist Leon Festinger and has a fascinating origin. Festinger began to develop the concept in a 1950’s study of a cult whose participants believed the earth was about to be destroyed by a flood. When the flood’s predicted date came and went, and the world was still intact, Festinger’s ensuing interviews revealed that fringe members of the cult were more likely to acknowledge they had made fools of themselves. However, the committed cult members who had given up homes and jobs to work for the cult re-interpreted the evidence. These cult zealots believed their faithfulness prevented the flood from occurring and hence they were right all along.

Most would identify the zealots’ reactions as self-delusional. Indeed, self-delusion is how most people cope with cognitive dissonance as we are apt to reject anything contrary to our beliefs once we form an opinion on a specific topic. Self-delusion rarely leads to good decisions. Instead, it leads to decision-making errors as humans attempt to resolve the mental discomfort (i.e., reduce the dissonance) from the inconsistency of their beliefs and the new information by one of two shortcuts:

  • Add confirming beliefs – try to build a case to support your view by finding evidence that outweighs the conflicting information. For example, if Mr. X purchases a stock that subsequently declines in price, rather than acknowledging he made a mistake, Mr. X instead seeks out opinions from others that support his original purchase decision.
  • Ignoring information – simply disregard any information that does not support your belief. For example, continuing to add to a losing investment in spite of increasing evidence that the prospects for the holding are deteriorating, i.e., “throwing good money after bad.”

Neither of these actions is rational nor representative of a good decision-making process, even if they reduce the discomfort of the decision itself. Rather, better paths to decision-making that maximize one’s self-interest while minimizing dissonance are illustrated in the other three boxes of the chart below: Change the Behavior, Change the Belief, or Analyze the new information and Dismiss it as invalid.

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In real life, changing your behavior or belief is easier said than done (smoking is a good example, as despite the scientific evidence of its health effects, many people won’t give it up). Moreover, not all new information is valid, especially in today’s world, where the Internet gives everyone a megaphone to broadcast their views. Therefore, sometimes the correct decision is to dismiss the new information, just don’t do so on the initial premise that it conflicts with your view or belief.

More than ever, it’s critical that through self-introspection, each of us understands the origin of our beliefs and the data that supports them, so when presented with conflicting information we can assess its validity and whether it merits a change in our thinking. As we sift through the myriad of data points, we need to guard against the mental shortcuts to reducing dissonance and be open to new ideas that challenge our thinking to evolve emotionally and intellectually.

Be well,

Justin