Fear trade still in play
Fear trade still in play | By: David Pett
Fear is a huge motivating factor in the markets even in the best of times. Investors are almost always concerned — or should be — about corporate earnings falling, interest rates rising and whether the reward of an investment outweighs the risk. To be sure, some fear is a good thing. It’s a rational response when market conditions behave erratically and is usually short term in nature.
For instance, the over-riding fear that strangled equity returns in 2011 has recently dissipated more or less, with a strong rally in 2012 based on new hopes that Europe, and the rest of the global economy by extension, will finally climb out of the hole. But as this past week’s heightened market volatility demonstrates, investors are still deeply concerned about the risk of another major sell-off and aren’t willing to wave the “all clear” sign just yet.
“Absolutely, there is some hesitation in markets,” said Colin Cieszynski, a market strategist at CMC Markets Canada in Toronto. “We have had two big market crashes in the past 12 years so people have a right to be apprehensive.”
Many other analysts, however, believe fear has become more systemic and that investors are deeply concerned that the capital markets are fundamentally flawed and verging on collapse.
“Systemic fear is a class of its own. It has little to do with the periodic downswings that make capitalists cautious,” noted Jonathan Nitzan, a professor of political economy at York University, and Shimshon Bichler, who teaches political economy at several colleges in Israel, in a research paper published in 2010.
Fortunately, Mr. Nitzan and Mr. Bichler found that periods of systemic fear have seldom occurred in the age of modern finance. The first time was during the Great Depression of the 1930s, but the second started following the tech bust of 2000 and it has carried on through the 2008 financial crisis and the current sovereign debt crunch in Europe.
At such times, investors forget that asset prices are supposed to be forward looking. Despite knowing that crises come and go and that recession always gives way to expansion, investors become consumed with the latest economic data and hang on every action or word uttered by purchasing managers and policymakers.
“The current news may be good or bad, revealing or misleading — but, then, investors aren’t supposed to take their cue from the current news in the first place,” they wrote. “Needless to say, such behavior is entirely improper.”
Mr. Cieszynski said that investors’ time horizons have dramatically shortened over the past few years because the market has become increasingly unpredictable. But fears aren’t nearly as heightened as they were last summer when decisions were being made “by the hour.”
He said the recent spike in volatility — fueled by more fears of Greece defaulting and a weak Chinese GDP forecast — that saw Canadian equity markets fall more than 250 points on Tuesday and then more than fully rebound over the next three days, was more about investors being vigilant than scared following an impressive five-month rally.
“It’s not the go-go charge ahead that we had in the 1990s and some periods of the past decade in certain sectors. Now, when the market gets to a certain point, investors are saying, ‘Wait a minute, let’s rethink,’” Mr. Cieszynski said.
“Markets climb the wall of worry. It keeps the markets getting too far ahead of themselves. When you do have people who are concerned and hold some back or take profits, it keeps a balance and you don’t get the bubble conditions that happen when people get complacent.”
Despite a growing optimism about the state of the global economy, Mr. Cieszynski believes the myopic tendencies of investors will continue until more consistent economic data comes in and people become more comfortable with the political environment. Even then, investor confidence may never go back to the way it was before the financial crisis.
“For the time being, people have learned enough hard lessons and are more willing to act first and ask questions later,” he said.
While that seems like a prudent strategy given all the turmoil that has transpired over the past few years, too much emphasis on current macro conditions overshadows the fact that there are some solid growth opportunities presently available in the markets, said Gerry Connor, CEO of Cumberland Wealth Management in Toronto. Even though markets might have some short-term corrections, he thinks the worst is over and that the markets bottomed last fall.
Nevertheless, investors continue to project the market misery of recent history into the future. As proof, Connor points out there is still US$8-trillion earning nothing in savings accounts south of the border and another US$3-trillion in U.S. Treasuries earning next to nothing. “Those are bigger numbers than I have ever seen in my life,” he said.
The future isn’t linear, Mr. Connor added, noting that asset prices must eventually revert to the mean. And, when compared to bonds, gold and real estate, which have all enjoyed bull runs over the decade, stocks are looking attractive.
“If you believe that things regress back to the long-term mean, than those first three asset classes look stretched, and the stock market, where there is the most fear, gives you the best risk-adjusted rate of return or margin of safety and seems to be the cheapest.”
Ultimately, Mr. Connor believes most investors already know these facts about the stock market and simply lack the conviction to act.
“It takes courage to pull the trigger and execute,” he said. “But eventually they will get tired of earning nothing in their bank accounts or the bond market will turn on them, and seeing the stock market continue to plug along, they won’t be able to stand it any longer.”
