Two trading weeks have passed since the US Federal Reserve cut interest rates. Emerging market stocks are on fire. Indeed, some of them have been on fire ever since the Fed cut the discount rate in mid-August. Brazilian Bovespa Index is up around 35% from the intra-day low on 16 August. India’s Sensex is scaling 1,000 points per week. Japanese housewives are also gingerly stepping back into the foreign exchange market. New yen shorts are being established and New Zealand’s dollar looks healthier again. The three- week swoon up to mid-August is an insignificant entry in our memory.
While the concern of the Fed and most other central banks until July was that financial market investors were giving very low consideration to risk, they have now acted in a manner that has halted the return to a more normal investment environment in which risk mattered. They have gone out of the way to restore an environment of complacency. Bernanke might yet go down in economic history as the central banker who brought the 25-year fight against inflation to an end. These are early days yet to say so conclusively. All signs are there, however.
Crude oil is holding well above $80 per barrel and wheat and corn prices are rising. Headline inflation in the US would be above 4% in September or failing that, in October. And, if, by some chance, the US employment numbers for September to be released on 5 October turn out to be strong, then Bernanke’s panic reaction on 18 September would turn out to have been hasty, ill-advised and, arguably, far worse than any error that Greenspan committed, since the actions of the former have now triggered an easing of monetary conditions elsewhere, much to the discomfiture of more prudent central bankers.
Talking to contacts in the industry, one gathers that if one-year maturity put options are offered on Bernanke as opposed to a Bernanke put on the market which he wrote on 16 August and 18 September, many are ready to buy. The reason may be that many of them were caught out by the quick and the huge recovery that has occurred in financial markets since mid-August, particularly since mid-September. There is a lesson here for the so-called smart investors or hedge fund managers—a lesson that was well flagged by Nicholas Nassim Taleb in his book, Fooled by Randomness.
Many smart investors had correctly anticipated the financial market repercussions caused by the excesses of structured finance and the rise in credit risk premium when the structured finance ponzi scheme showed signs of unravelling. Hence, as soon as the stock markets began to decline in August, investors concluded that apocalypse had arrived. They quickly closed long positions and went short. It was going well for some of them until mid-August. But, on 18 August, paying heed to warnings that technical indicators in many markets were breaking down, the Fed cut the discount rate. That put a floor under many stock markets. Then came the rate cuts two weeks ago and the fire was lit under all the global markets. The largesse of the Fed, together with the positioning in the market, has fuelled the exaggerated reaction in stock markets to this day.
Why do many smart investors feel frustrated? First, technology and the availability of real-time and round-the-clock data induce many managers to believe they have superior market-timing capabilities than their less well-informed and more passive brethren in the outside world. Information and its availability at fingertips encourage hyperactivity. They end up overtrading. Then, when things go against them, their reactions swing to the other extreme. They feel frustrated, stupid and cheated. That’s again because of too much information. They look at their portfolios every minute, every second and see their net asset value going down every day, whereas simpler-minded investors do better.
An insightful market observer recently told me that top-down and intelligent investment strategists should learn to arrive at their investment outlook and be prepared for it to materialize in 12 months and, further, recommend the opposite for the present! Market opinion might be slow to change while some investors could see (too) far ahead very clearly. This may well bear out in the current context.
Finally, Taleb wrote correctly in his book that looking at portfolios too often did not add either to portfolio performance or to self-esteem or to happiness. In fact, it subtracted from all three of these. Much as some of us did not approve of what the Federal Reserve did on 18 September, our investment recommendations ought to be based on the likely market reaction than our likes and dislikes. Frustration arises and performance drops when we take investment positions on the basis of what we would like to see happen than what is likely to happen.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org