Is the World More Uncertain than We Think?

Joan Alexandre, Investment Analyst
December 26, 2018

When What You See Is All There Is

In 2011, Nobel laureate and research psychologist Daniel Kahneman published “Thinking, Fast and Slow”. This New York Times bestseller written with frequent collaborator Amos Taversky¹ encapsulates decades-long research into the factors governing human judgment and decision-making. A particular focus of their research is how human judgment in practice runs counter to the notion decision-making always seeks to maximize utility.

Describing the two different ways by which the brain forms thoughts, Kahneman identifies the instinctive or emotive fast thinking as System 1, whereas System 2 is logical and calculating or slow thinking. During our waking hours, both systems are engaged with System 1 handling most of the cognitive load — unless something unexpected occurs. Slow thinking tackles the problems arising from the unexpected.

Although fast thinking is generally very accurate, its weakness is the tendency to create coherent and believable narratives based on limited, or absent, evidence. Moreover, when impressions are formed in the belief that what you see is all there is, fast thinking often identifies causal connections between events. This can often occur even when no connection exists.

A once unchallenged view in modern investment theory and practice was the conviction that stock market prices fully, automatically and accurately reflect all available information. The Efficient Market Hypothesis represents a frictionless ideal: a stock market free from transaction costs, taxes and information asymmetry ― where excess returns are theoretically impossible. However, the practical application of the Efficient Market Hypothesis reveals some frailties. Likely the result of those whose actions constitute “the market” ― people.

Consistent among Kahneman’s cross-sectional analyses: people base broad predictions of future events – what they think is going to happen – on limited data while ignoring or rejecting evidence that supports a different conclusion. In research sciences, this is referred to as confirmation bias.
Another counterpoint to the theory of rational markets is that when it comes to investments, the decisions we make determine the gains and losses we experience. Human inclination is to use situational framing when making these decisions.

Another counterpoint to the theory of rational markets is that when it comes to investments, the decisions we make determine the gains and losses we experience. Human inclination is to use situational framing when making these decisions.

Even efficient markets proponent, Peter L. Bernstein, acknowledged the integrity of Kahneman’s and Tversky’s work. In his 1996 book “Against the Gods: The Remarkable Story of Risk”, Bernstein describes the framing effect in detail:

“We display risk-aversion when offered a choice in one setting only to become risk-seekers when offered the same choice in a different setting, ignoring the common components of a problem and concentrating on each part in isolation / We have trouble recognizing how much information is enough and how much is too much. As a result, we forget about regression to the mean, overstay our positions, and end up in trouble.”

A real-world illustration of this bias is how an investor responds to price fluctuations of his or her investment portfolio. Often, an investor is more likely to embrace risk as stock markets rally only to shun risk during sell-offs. Couple this with the fact that investors often feel declines far more acutely than when markets rise and one can see why many investors commonly buy high and sell low. On that note, it’s important to point out that a decline only becomes a loss and a rise only becomes a gain when the investment is sold.

Although some characterizations of Kahneman’s research in behavioral economics point to humans making irrational decisions when it comes to utility, Kahneman steadfastly disagrees that humans behave irrationally.

Instead, certain judgments and decisions deviate, identifiably and repeatedly, from idealized economic utility models. The first 30 years of Kahneman’s career examined how biases contributed to these deviations. However, he is now devoting his energies to the ways noise, or random variability, affects decision-making.

The Market Giveth

Given the clear-sightedness hindsight provides, it would appear that 2017’s supremely tranquil stock markets led experts and individual investors alike to make some System 1 errors, which have been exposed by the big market swings we’ve seen in late 2018.

In 2017, the S&P 500 advanced 21.83 percent. This represents the third largest calendar-year gain since the 2008 financial crisis and accomplished this feat without much volatility. Only eight trading days in 2017 logged rallies or drawdowns greater than 1 percent.

In contrast, the first and second largest calendar-year gains seen since the Great Financial Crisis began were in 2013 (up 32.39 percent) and 2009 (up 26.46 percent).

The stock market rally in 2009 was achieved with more than 100 trading days of market moves greater than 1 percent. It wasn’t uncommon to see prices move more than 4 percent in either direction over one or handful of trading days.

In contrast, the 2013 stock rally accomplished big gains with much less stomach-churning volatility. During the year, stock prices moved greater than 1 percent (up or down) only 38 days of the year – only one-third of the number experienced in 2009.

The tranquil consistency of 2017 is also evidenced by the positive returns experienced every single month of the year – a feat last achieved in the late 1950s.

The 2017 stock market rally was broadly based with consumer discretionary, materials, industrials, healthcare and financials all returning 20 percent or more. In the July 24, 2017, edition of GSAM’s Global Markets Daily, Goldman Sachs’ chief equity strategist David Kostin observed:

The forward P/E multiple of the S&P 500 has risen by 80 percent since 2011 (to 18x) and now trades at the 89th percentile compared with the past 40 years while the typical stock is at the 99th percentile of historical valuation.

Goldman Sachs was not alone in this view of lofty equity valuations. The Bank of America Merrill Lynch's global investor survey (April 2017) revealed that a record 83 percent of fund managers thought U.S. stocks were overvalued. Even the Federal Reserve’s meeting minutes from March 2017 included the advisement that "some measures, such as price-to-earnings ratios, rose further above historical norms with equity prices quite high relative to standard valuation measures."

Despite several equity strategists highlighting the historically high, and unsustainable, prices investors were willing to pay for $1.00 of earnings, these warnings were largely ignored. Instead, return expectations remained anchored to continued low interest rates, low inflation and higher profits amid slower growth outside of the U.S.

A prolonged stretch of positive economic news was certainly a factor in last year’s hardy returns. However, the rush of investor enthusiasm fed an ever-increasing risk appetite – aka momentum – and was the bigger catalyst for this rise upward. Stock markets were also provided an assist from news and events – nothing near the serious headline risk we’ve seen in 2018.

And the Market Mean Reverts

After an auspicious start to 2018 with the S&P 500 gaining 5.73 percent in January, February took a big swipe at investor optimism. On Friday, Feb. 2, a stronger-than-expected labor report suggested that inflation – long-dormant in the United States – had returned. Fearing more aggressive rate policy from the Federal Reserve in response, investors broadly shed stocks.

The 2 percent Friday selloff in February appeared downright orderly compared to the following Monday when U.S. markets fell more than 4 percent. This decline was exacerbated by the unwinding of short-term bets against volatility – which imploded spectacularly, catapulting the Wall Street’s “fear index” – the CBOE Volatility Index (VIX) – over 110 percent in one day.

If March was an improvement over February, it was only slightly so ― losing 2.54 percent versus the prior month’s 3.69-percent decline. Arguments supporting continued bullish sentiment might have held off the worst of 2018’s volatility if not for a critical economic pivot in March. President Trump enacted sweeping steel and aluminum tariffs on China, Canada, Mexico and the eurozone with increasingly more aggressive trade barriers to come.

As readily as Bank of America-Merrill Lynch and Goldman Sachs strategists suggested higher equity valuations had but tenuous support, they just as assuredly dismissed as “modest” the potential economic effects of trade barriers. A respite from market tumult seemed to affirm this. The period from April 1–to–Sept. 30 mirrored 2017’s pattern with consistent monthly gains and very few large price swings. In 130 days of trading, the market moved greater than 1 percent only 10 times — eight of which were strong moves to the upside.

Just as memories of the year’s earlier reversal began to fade, October delivered a “fright fest” for investors as the S&P 500 sold off 6.84 percent. Accompanying the broad investor rotation out of equities into less risky assets was a significant increase in headline risk. One example was a report from Bloomberg News that revealed that the trade tariffs were already negatively impacting third quarter profits of blue-chip companies such as Coca-Cola, Toyota, Wal-Mart, Ford and Alcoa who were contending with compressed profit margins from increased costs.

Survival Adaption is not an Investment Advantage

Necessary for both survival and innovation, Kahneman points out that optimism may be fundamentally at odds with solid investment decisions. Optimism is the fuel allowing humans to fail frequently, and yet persist. However, this persistence comes with a cost — excessive risk taking. Moreover, he argues “having been successful is not a guarantee of future success. But it’s almost always a guarantee of future overconfidence.”

Throughout his research and the book, Kahneman stresses that intuition, or fast thinking, is frequently spot-on ― often, life-savingly so. Nevertheless, the conditions necessary to hone this sixth sense are very specific, involving practice, immediate feedback and a measure of “regularity in the world you can pick up and know”.

As an example, he cites the experienced fire chief who pulls his crew back from a burning building prior to its engulfment. This intuition was forged over many years of fighting fires, observing ignition and burn patterns and the consistency of the physics of fire.

Staying True to Your Beliefs

Regardless if you’re an investment professional or a Main Street American, big drops like what we’ve recently experienced in U.S. stock markets have a cognitive impact. Investing is both a science and an art, with a rich history of brilliant ideas and research like Kahneman’s which has shaped the past and will influence the future. Knowing what you believe helps to illuminate the path before you more clearly and supports the essential conviction that guides your ability to meet long-term investment goals.

1st Global’s investment programs are shaped by 11 well-defined investment beliefs that guide our process, determine our actions, influence our investment management decisions and serve as the truths and principles behind our investing philosophy.

We know long-term investing is a journey filled with perpetual hurdles, cognitive mistakes, nuances, hard analysis and constant change. Being thorough in understanding the truth behind your actions, staying the course when your emotions are trying to overcome your logical thoughts and reasoning abilities, focusing on your long-term promises and not letting fear overshadow your vision of your future are all essential in helping you make wise investment decisions.

 

About Joan Alexandre
Joan Alexandre is an investment analyst in the Investment Management Research Group (IMRG) at 1st Global, where she conducts due diligence on existing and prospective investment managers, collaborates in the review of strategic asset allocation, contributes to decisions regarding investment selection and manager roles, and structures the output to support the investment decision-making process. She has been in the financial services industry since 2008 when she received an opportunity at a startup company. Prior to joining 1st Global in 2017, Joan has managed market data services, served as a financial advisor and investment analyst/wealth strategist, and provided consulting services for multiple private companies.

About the Investment Management Research Group
The Investment Management Research Group (IMRG) of 1st Global is a team of tenured investment professionals that operates under the oversight of the 1st Global Investment Committee and is tasked with finding “best-in-class” investment managers and products for use across the IMS Select Portfolios strategies as well as other IMS programs. The team’s primary responsibilities include portfolio construction and investment manager due diligence, monitoring and selection. The team brings years of experience and investment knowledge to help guide clients with asset class allocation and individual fund selection, which are aimed at providing optimal risk-adjusted returns within each risk category.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. This commentary should not be considered a solicitation or offering of any investment product. Neither asset allocation nor diversification assures a profit or protects against a loss in declining markets.

Past performance is no guarantee of future results. Index performance does not reflect the deduction of any investment-related fees and expenses. It is not possible to invest directly in an index.

The S&P 500 Index is a free-float market capitalization index of 500 large publicly held U.S.-based companies, capturing 80 percent coverage of U.S. equities. It is often used as a proxy for the American stock market.

The Chicago Board Options Exchange Volatility Index, or VIX, as it is better known, is used by stock and options traders to gauge the market’s anxiety level. It is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days and is quoted as an annualized standard deviation.

Source of Returns: Morningstar Direct

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