Keeping the Ship Steady

September 20, 2022 —

In the article How to Stay Rational When the Markets Go Crazy, Dr. Charles Lee wrote for Stanford Business School:

“We have many studies on this topic, and they all point in the same direction: Investors are remarkably bad at timing markets, and they ultimately fare worse for the effort.

“Whether we are talking about the stock market or individual mutual funds, money tends to chase performance. Strong performance in one period attracts new investors in the next period. Unfortunately, time and again, most of those investors arrive just before the market peaks, and most of them sell just before the market bottoms.

“Evidently most investors are either caught up in the sentiment waves themselves or are trying to outmaneuver the sentiment of others. Either way, it doesn’t work. You might as well be in a hall of mirrors.”

* * *

There’s an extensive literature documenting the behavioral biases of some investors, as the above quote demonstrates. In a well known paper, Greenwood and Shleifer show that investors systematically get their market forecasts wrong, thinking that future returns will be low when, in fact, they turn out to be high, and vice versa.[1]

To be sure, it is very hard to forecast the direction of the overall market. That’s why, at QuantStreet, we don’t try to do that. We use a systematic return forecasting and portfolio allocation approach that allows us to target the highest possible expected returns at a given risk target. We focus on asset allocation, rather than market timing.

Our methodology is thus not subject to the vagaries of investor and market sentiment, a feature that is particularly valuable during such volatile times. Read on for our take the on the price action in markets over the last week.

What is Going on with the Markets? 

Expectations are a powerful thing. If you’re wondering what happened to financial markets over the last week, it all started last Tuesday morning, when the CPI numbers came out at 8:30 AM. The market was expecting 6.1% year-over-year growth in core (ex-food and energy) inflation, but got 6.3% instead. Doesn’t sound like much, but obviously this was a huge deal for investors. Why? Because of the readthrough to what the Fed will do at tomorrow’s meeting.

The inflation narrative had evolved to where investors believed inflation was trending back down (and it probably is, see below), which would allow the Fed to be less aggressive. But with core CPI surprising on the upside, people now think the Fed will need to be more aggressive, if for no other reason than to maintain its own data-dependence credibility. (Take a look at the recent increase in 2-year Treasuries to get a sense of the market’s changed beliefs about Fed policy.)

If you look at last week’s CPI increase in a slightly larger context, for example in comparison to the PCE inflation measure (which is the Fed’s preferred metric, and is less noisy because housing plays a much smaller role in the PCE), you notice that (1) this increase doesn’t look all that high relative to the volatility of the CPI measure, and (2) divergences from PCE sometimes self-correct with the CPI reverting back to the PCE over time.

It all feels a lot like a tempest in a teapot, but that tempest has been all too real for investors.

By the way, last Friday’s market pain was because of a (really) bad earnings warning from FedEx. When one of the largest logistics companies is seeing weak demand, it makes one question just how much inflationary pressure is out there (and how much Fed tightening has already slowed things).

The lack of inflation fears is supported by the fact that breakevens are largely unchanged over the last five days, suggesting investors, while thinking the Fed will be forced to be more aggressive tomorrow, don’t actually think future inflation will be any higher than what they believed a week ago.


[1] Expectations of Returns and Expected Returns, Review of Financial Studies, 2014 (this study measures investor expectations using six different investor surveys from 1963 to 2011).

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