Why Stock Market Will Always Be Totally Unpredictable

 

Book Excerpt: Why Stock Market Will Always Be Totally Unpredictable

In his book ‘The Joys of Compounding: The Passionate Pursuit of Lifelong Learning’, Gautam Baid shares how his thinking on stock investing has shaped over the years, his experiences as a value investor and the learnings he has picked up along the way from some of the most well-known equity investors

You may have noticed that all of these bull market definitions are completely subjective. They don’t say that bull markets are over once we hit certain predefined valuation targets or market sentiment survey levels.

The best investors are willing to humbly admit that market cycles do not exhibit any certainty or predictability. On this topic, you should completely ignore the so-called market experts, talking heads, and macro forecasters. It is impossible to know exactly when a market cycle will end, because the pendulum can swing too far in either direction. The challenging aspect of risk management in the stock market is that you can only approximately and qualitatively evaluate the extent of risk but can never precisely time the trigger that will cause this risk to play out. Former Federal Reserve chair Alan Greenspan’s highly publicized “irrational exuberance” comments were made in 1996, but the tech bubble popped only in March 2000. John Maynard Keynes rightly said, “Markets can remain irrational longer than you can remain solvent.”

For every data point on stock ownership or investor sentiment that shows stocks are overvalued or undervalued, a logical-sounding corresponding counterargument exists. Any time you see a data set or a single data point attempting to define the current stage of the stock market, treat it with skepticism. Markets are driven by emotion. And sentiment, existing only in the minds of human beings, is subject to abrupt change without any notice. (The market is characterized by meta-randomness. Stocks are conditionally random on news. News is conditionally random on people. People are conditionally random on moods. Moods are conditionally random on mind-set.) Trillions of moving parts are involved, so it is simply impossible for a single variable or even a handful of variables to tell us exactly when the good or bad times will end.

It is easy to make logical arguments with data, but far harder to convince someone to forget their feelings. If investors experience an extreme economic or stock market event in the first decade of their career, they tend to obsess over it repeating for their lifetime. We have been inundated with crash calls since 2009. (Much of this is due to recency bias, because we have witnessed or experienced in the past twenty years three of the most widely documented crashes in the market history). Many intelligent arguments explain why the bull market should have ended. It just hasn’t mattered until now. And it never will. The stock market will always be totally unpredictable, because it is a complex adaptive system. (George Soros’s reflexivity theory suggests that markets cannot possibly discount the future because they do not merely discount the future but rather also help to shape it. Reflexivity is, in effect, a two-way feedback mechanism in which reality shapes the participants’ thinking and the participants’ thinking shapes reality, in an unending loop.)

Investors spend too much time trying to determine which year the current market setup resembles. Is this 1999 all over again? Is it just like 2007? How about 1987, or better yet, 1929? (Fun fact: if you check Twitter during times of sharp market movements on either side, you will observe people posting images or data drawing parallels between the current market situation and past extremes.) Investor actions are shaped by their most recent experiences, so 2020 is just like 2020. The only constant is that investor emotions shape market behavior, especially over shorter time frames. This is why Templeton, Marks, and Ivanov all use market psychology to describe bull markets and not long-term, cyclically adjusted, P/E ratios. (The cyclically adjusted P/E ratio, commonly known as the CAPE ratio or Shiller P/E, is a valuation measure typically applied to the S&P 500 and is defined as price divided by the moving average of ten years of earnings, adjusted for inflation.)

Market cycles are impossible to call with any precision. The best we can do is use the process of elimination to identify where we are not. As Howard Marks aptly put it, “You can’t predict. You can prepare.”

As of today, most investors are well past the pessimism and skepticism stages (except for those who have been wrong the entire way up). Improvement is under way. There is no blood in the streets. There are no babies being thrown out with the bathwater. It is not the time to get greedy.

Do these conditions mean it is time to sell all your stocks because of the huge gains made since the most recent market crash?

Whether or not to sell depends on an investor’s time horizon, which is the primary determinant of how risk is perceived and experienced. The more time you have, the less risk you bear. Patience is a great equalizer of cycles in the financial markets. Time in the markets with good businesses, not timing the markets, drives wealth creation. This is what Peter Lynch was referring to when he said these golden words: “The real key to making money in stocks is not to get scared out of them.”14 Low- and negative-return years are a routine part of the investing game. You have to be present in this game for a long time to win. The key is to avoid getting thrown out midway because of reckless decisions. We cannot control the direction of the market or what returns it will give, but we can control some essential aspects of the investing process.

Gautam Baid is a portfolio manager at US-based Summit Global Investments. He has worked at Deutsche Bank as senior analyst in their healthcare investment banking teams, and also Citigroup

 

Happy Investing

Source: Moneycontrol.com