Are equity markets rational? The favoured argument among active fund managers is that they are irrational in the short-term, and rational over the longer-term. In the short-term, they are buffeted by economic noise, short-term and passive investors, and the machinations of central bankers, but over the long-term a company’s fundamental economic characteristics will emerge and be reflected in the price. But does this premise bear examination?
Impossible to Buy Undervalued Stocks?
The ‘efficient market hypothesis’ proposed by Professor Eugene Fama has come under increasing scrutiny in recent years. He argued that stocks always reflect all the available information and therefore always trade at their fair value, making it impossible for investors to buy ‘undervalued’ stocks. This has been challenged by academics including Justin Fox, who wrote the “Myth of the Rational Market”, Robert Shiller, who won a Nobel prize for predicting both the Internet crash and the housing bust and Lawrence Summers, now a senior official in the Obama administration. Their arguments differ, but they all agree that markets are – at best – rational over the longer term and certainly not over the short-term.
It is a question worth asking in the current market environment because many commentators have suggested that the sell-off is irrational, based on weak analysis of the situation in China. If the sell-off is indeed irrational, and investors can expect a speedy reversion to the norm, then this would be a good time to buy equities.
What is Driving these Irrational Markets?
Didier Saint-Georges, head of the investment committee at Carmignac argues that market pricing is driven by three main elements: fundamental stock characteristics, liquidity and sentiment. While liquidity and sentiment may exert an influence in the short-term, the market should revert to a focus on fundamental stock characteristics in the long-term.
With this in mind, there are currently three elements that may be introducing an ‘irrational’ element into markets. The first is the weight of passives in the market. According to the Investment Association, in the UK market, passive investors are still a smaller part of the UK market than active investors at around 20% of overall UK asset management activity, 23% when smart beta is included. However, their influence may be disproportionate at times of thin trading – as has been seen since the start of the year – or at times when active managers choose not to trade – as may be the case at times of heightened volatility. St Georges says: “By definition, passives are momentum investors and as such, they are increasing the magnitude of the volatility.”
Fear of Risk Creates Risks
Tim Cockerill, head of research at Rowan Dartington, also highlights the impact of risk limits put in place by many fund groups in the wake of the financial crisis: “After the Financial Crisis a lot of funds introduced risk measures around volatility. They now try to keep volatility in a band. This means that if there are spikes on the upside or downside, the fund manager must sell. That impacts the market and creates increasing volatility. This starts a vicious cycle – a system designed to control risk has the opposite effect.”
The second is the influence of central bankers. Saint-Georges says: “A new era started in 2009, which brought a huge amount of inefficiency. Central banks set out to encourage investors to move to riskier assets and this significantly impacted the way investments are selected. There is a danger than people try to anticipate central bank behaviour rather than the price based on the fundamentals of a company.”
Central bankers have a role in the third element as well – market liquidity. Part of the current problem is that liquidity is being withdrawn from markets. Investors keen to get out of markets may sell those stocks for which there are buyers rather than those stocks they necessarily want to sell. This can also create irrationality.
But a number of things argue against increased market inefficiency: For example, market volatility has not fundamentally increased over the past 25 years. If passives and risk parity funds were having an increased influence on markets, volatility would be expected to be structurally higher in recent years as both types of fund has grown. Yet, barring a brief spike around the time of the financial crisis in 2008, volatility – as measured by the Vix index – has remained relatively stable over the past 10 years. Looking further out also does not support a structural increase in volatility – volatility remains at or around the same level as it was in the 1990s.
Individual Stocks React Differently to Market Pressures
It is also clear that specific company characteristics can have an influence, particularly on the negative side. Although commodity stocks may have formed part of the rolling risk-on, risk-off trade led by central bankers, the market discriminates: BP (BP.) is down 19.2% over the past year, compared to a 63.35% fall for Glencore (GLEN). For companies such as Tesco (TSCO) or Rolls-Royce (RR.), company-specific problems have had a particular influence on share price behaviour.
This would suggest that while equity markets are buffeted by various elements, company characteristics still have an influence.
The real problem may come in other, less liquid markets such as corporate bonds, where technical factors, such as the withdrawal of liquidity, exert a disproportionate influence. However, that is not to say that as passives become more popular – both in equity and bond markets – the ‘rational’ element of markets may diminish.
