It is quite striking that over the past decade the rational markets fallacy was actually taken very seriously…by grown-up men!
In fact, rational markets became the fundamental assumption in MBA programmes and academic research—the notion that markets were populated by rational actors independently assessing the available information and scientifically, independently seeking to maximize their own returns…
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…This would all be very entertaining and not terribly relevant except for the fact that financial markets have essentially broken loose from their theoretical function, the rational distribution of capital to the areas of highest marginal returns, as they become increasingly decorrelated with the underlying economies.
If you think back to the 1960s—and this was a good time in the Western world— steady, incremental growth, the middle-class growing wealthy and self-assured, with people assuming that the future could only be better than the present.
In those simpler days the financial system accounted for only about 3 ½% of US GDP—in Europe, considerably less… Now, a few decades later and it is consuming fully 8% of GDP—…—and remember, it provides no useful goods and services—it is—we are—a cost centre. And some people think that governments are inefficient?
The immediate problem is that the extreme volatility and irrational hyper-correlation are nullifying what was supposed to be the ultimate economic function of the financial system—i.e., the rational allocation of capital... The wild volatility appears to be largely due to the gap between liquidity and valuation. The Central Banks pour in cash and asset prices respond, surging until the gap between price and valuation becomes unsustainable, leading to a sharp correction; this scares the authorities—more support is poured in, and we start over again…
As I contemplated what to write for my weekly column, I decided that if I had nothing original to say, I could do worse than quote others who have said more meaningful things more intelligently. That is what I have done by quoting from the presentation by Russian fund manager Eric Kraus at a conference in Canada.
You can download the presentation from www.research.open.ru/en/truth_beauty_eric_kraus/ and email him for the text to go with the presentation. It is worth the effort.
As financial markets become “decorrelated” with underlying economies, it is no surprise that they are increasingly correlated with one another.
In an exclusive research note prepared for clients, CLSA Research wrote that a whole range of differentiated assets continue to trade as one undifferentiated mass. I could not have put it better than this:
“It’s almost as if you typed in ‘investments to buy’ into Google and got pictures of a gold coin, a chemical plant, a 500 Euro note and the exchange traded fund (ETF) for US banks. They aren’t the same—not by a long shot—but to the global capital market, they all look the same.
“US equity correlations among the 10 industrial sectors of the S&P 500 remain near historical highs, as 7 out of 10 sector ETFs show correlations with the S&P in excess of 90%. Foreign and emerging market correlations continue to stick near historic high correlations, with their respective ETFs showing price correlations in excess of 90% (with the S&P 500 industrial sectors).”
The only decision left for us to make is what to call this—comedy, farce or tragedy. Certainly, comedy is ruled out by the fact that approximately $5 trillion (or more) has turned over in Asia (ex-Japan) stocks in the last 12 months, even with the MSCI (Asia ex-Japan) index spending two-thirds of the last one year in a tight range of 10%.
Far from calling their bluff, governments and media are feeding the tamasha with lies, exaggerated claims and breathless speculation on the direction of these (correlated) markets. In the US, the Bureau of Labour manufactured a piece of weekly data since many states could not file the true data due to the long weekend for Labour Day holiday.
The stock market rose on the manufactured weekly data since it turned out to be a tad better than the consensus forecast. Yes, there are forecasts made for weekly data. Forecasters provide these solemn forecasts, financial market participants take them seriously and the media hyperventilates on them, comparing the actual data with the forecast. No one notices when the actual data are quietly revised to reveal a complete different picture of reality a few weeks down the road. There is no need to waste our breath on the data quality and reliability in wannabe superpowers.
The last time all risky assets traded with a high degree of correlation to one another resulting in capital markets badly misallocating capital was during the leverage-based and policy orchestrated boom that lasted up to 2007. That the world of finance is back at it barely two years after the crisis is the worst indictment not only of the rationality of the collective capital market but also of its individual participants.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org