Complacency Throws Markets Off Course

 

Foreword from ShareInvestor

This article “Complacency Throws Markets Off Course?” by R SIVANITHY was first published in The Business Times on 11 Oct 2017 and is reproduced in this blog in its entirety.

Students of statistics and other social sciences would be familiar with the phrase “regression to the mean” that broadly means there is a long-term equilibrium towards which phenomena will tend towards.

The person who discovered it was 19th century scientist Francis Galton who found that tall men were more likely to sire shorter sons and that short men were more likely to father tall sons, as if some mysterious force was causing human heights to move away from extremes towards some kind of average for all humans.

This of course makes perfect sense because if tall men had tall sons and short men short sons, then the world would eventually be filled with very tall and very short men with little in between.

Since this not the case, it would be safe to assume that somehow, the natural order of the world requires people’s heights to regress towards some sort of average or mean so as to maintain some semblance of balance and equilibrium.

As applied to the stock market, regression to the mean refers to some kind of stable, long-term average towards which prices will gravitate, though unlike in biology it isn’t driven by a genetic imperative but instead by the very human emotions of greed and fear. And, for decades, these opposing forces have acted as they should, pushing stocks up when greed takes grip and dragging them lower when fear kicks in.

So it was that market movements followed some kind of regular rhythm, not necessarily one that was predictable but certainly one that over time resulted in prices that made sense.

Stated differently, even though stocks regularly deviated from their optimal levels – thus enabling supernormal profits to be made – investors could be assured that some sort of equilibrium would prevail and that assets would generally be allocated to their best possible uses after adjusting for risk. This is no longer the case following the US sub-prime crisis of 2008 and the extraordinary lengths that the US Federal Reserve and other Western central banks took to rescue their sinking economies.

Throughout the past nine years, two forces have acted on Wall Street to drive complacency up to unprecedented levels, interfered with the natural evolution of prices and thrown regression to the mean off course.

Artificially Depressed

The first is the slashing of interest rates to zero and keeping them artificially depressed for several years. Assuming that the cost of credit, like any other commodity, should be determined by the forces of demand and supply, then forcible depression such as this amounts to prolonged interference that has upset the natural balance.

If so, then the long-term equilibrium towards which prices should have gravitated is no longer realistically probable or in focus; instead, we have a constantly rising target that is heavily driven by greed and fear, though the latter is not fear of monetary loss but fear of being left out.

This is because of the second factor at work, the explicit guarantee that markets have from central banks like the Fed that if trouble was to strike, rates would again be driven down and money printed to bail everyone out. The moral hazard present in such an assurance has been readily observable over the past eight years – with no need to worry about risk because of the presence of a Fed-created safety net, Wall Street has continued rising and has dozens of all-time highs.

Thus it is that the VIX Index which tracks the options market’s expectations of future volatility, is currently at a 20-year low, a clear indication that risk is no longer part of the equation. Looked at differently, if the market does not expect much volatility ahead, then it’s possible to say investors are super-complacent.

 Wall Street Belief

Wall Street, which is supposedly the world’s most liquid and efficient stock market, now believes that prices will continue to head higher with no end in sight even when the nuclear threat from North Korea has not subsided, interest rates are rising and notwithstanding the fact that the Trump administration, which has failed in its bid to reform healthcare, will face monumental problems pushing through its tax proposals.

This is where markets find themselves now and what the endgame might be is anyone’s guess. If risk is not on the table any more, then thanks to the explicit guarantees from central banks, most notably the Fed, regression to the mean can no longer be counted upon as a driving force in markets.