When reality falls significantly short of expectations, what occurs is a breakdown of the relationship between the factors investors are using to predict returns and realised market performance. Disconnection of markets from their underlying fundamentals, which makes it more difficult to predict expected returns, is a self-reinforcing phenomenon, however. Uncertainty breeds uncertainty so when investors as a whole suffer a shock, they behave more irrationally than usual, increasing the disconnection.
“The trick is working out what sentiment will be like in the future,” says Paul Sweeting, European head of the strategy group at JP Morgan Asset Management. “The problem is there is no way of predicting forward volatility.”
What can be predicted however, is that investors will respond to periods of good or bad performance. Past experience feeds investor confidence and, if a mood prevails over a period of time, a trend is born as investors herd one way or another. Behavioural finance suggests a prediction such as the January Barometer is self-fulfilling. If investors’ confidence increased following a strong January, they might behave more rationally in the following months, thus reducing volatility, further increasing confidence and so the virtuous cycle goes. Momentum can, of course, be very beneficial to portfolios, as the Great Moderation proved. The critical thing is knowing when to get out of the herd.
Predicting inflection points, or the extremity of markets’ subsequent reaction, continually proves impossible though. Even experts who spend considerable resources and apply indepth technical analysis to identify trends, admit they cannot identify the start or end of a trend or how far they will carry markets until the inflection points are in the past.
According to Maria Heiden, investment advisor overlay management at Berenberg, which uses a systematic approach to get a mathematical algorithm that identifies past and future trends: “Forecasting when a market shock will hit or its extent cannot be predicted. At the end of the day, two things move markets – news and the behaviour of the market participants. Trends are the herd behaviour of markets reacting to news.”
The end of New Normal?
For now, the herd appears to be calming and re-risking, giving support to a correct outcome from the January Barometer by year-end. The great rotation back to equities appears to be firmly underway (see Big Picture). Volatility is at its lowest since pre-crisis times. The VIX closed at 12.98 on 7 August 2013, well below its rolling one-year average of 15.04, its lowest average point since mid- October 2007 and the first time average annual volatility has fallen below the critical 20 mark for 60 days or more since early 2008. Robert Quinn, chief European equity strategist at S&P Capital IQ, says markets could increase 8-10% by year-end and has a target of 325 for the Stoxx 600 by 31 December.
“Equity is still undervalued as an asset class,” Quinn says. “Bit by bit, we are coming out of the long, dark tunnel. We now have more ‘normalised’ macro-economic and investment markets, making the market a little bit more predictable. After having beta markets for two-and-a-half years, which saw sharp risk on/risk off periods, we are going back to the old norms as the world heals.”
Berenberg’s model is 80% positive on the Dax, EuroStoxx, Dow Jones and FTSE, and 60% positive on the S&P 500. However, according to Sweeting: “Things are looking positive, but we are only half way through the year. Who knows what the second half will bring?” Sweeting’s warning underlines uncorrelated returns are crucial to the longterm success of an investment portfolio as inflection points cannot be predicted and can be seriously damaging.
Predicting human behaviour and the accuracy of investor expectation that is priced-in to markets, which largely determines future outcomes, remains incredibly challenging if not futile. Trends can be historically identified that will determine the direction of markets in the medium term, tempting investors to abandoned hard-learned wisdom, but inflection points cannot yet be predicted. It is therefore unpredictability that should lie at the heart of portfolio management.
Waltham Forest Council pension fund chairman Nick Buckmaster concludes: “Identifying uncorrelated sources of return is what matters. Our ambition remains to stabilise returns. Doing so means we can place less reliance on predicting markets.”
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