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Portfolio > ETFs > Broad Market

People Get Creative When Explaining the Market Correction

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One of the more fascinating aspects about people and markets is how uncertain we are about what will happen next, yet so cocksure in our explanations of what just occurred. This raises an overlooked question: If it were so simple and predictable — obvious, even — then why didn’t we see it coming in advance and prepare for it?

Today, we shall consider some of the causes of the past week’s market unpleasantness. But before we do, we need to preface our remarks with an admission of error. Our wetware suffers from what psychologists describe as narrative fallacy and hindsight bias. In short, as a species we both like to tell stories — it makes thing more memorable — and we believe we have the ability to foretell the future, a power we clearly don’t possess.

With that as a preface, let’s consider some of the explanations for the sudden market correction:

Inverse and/or Short Volatility: The bet against market volatility suddenly blew up when volatility “unexpectedly” returned. I use quotes here because I find it unfathomable that anyone could believe that we wouldn’t see a return to a more normal trading environment. The Great Recession is receding as a once-in-a-generation event, along with zero interest rates, quantitative easing, fears of a collapse of the European Union and so on. Given how unusually placid 2017 was, this failing is even harder to grasp.

Valuations: The problem with blaming valuations for the correction is that since late 2009, people have been complaining that markets are overvalued. Market participants don’t wake up one day, realize stocks are expensive, then cause a correction. Investors have known this for ages.

Risk Parity: This is an odd thing to blame, as risk-parity funds have held up better than most. Cliff Asness of AQR eloquently takes apart this assertion much better than I can.

Wage Increases: Increased minimum wage laws, very low unemployment, tight labor market: These obvious forces putting upward pressure on wages and salaries have been visible for several years. Traders knew the dates of pending state and municipal wage legislation coming into effect in 2018. Markets may not get it perfect, but they usually do a decent job incorporating well-known information into prices.

Fed Tightening: The Federal Reserve has been especially clear and consistent during the past two years about a gradual return of interest rates to historically normal levels. The central bank, after years of supplying monetary stimulus amid and after the financial crisis, is getting off its emergency footing. Fed policymakers have repeatedly advised investors to expect three rate increases in 2108. Claiming that the most recent meeting of the rate-setting Federal Open Market Committee offered surprising news is simply not credible.

High-Frequency Trading: I have never been a big fan of high-frequency trading, thinking whatever it scalps comes out of the pockets of individual and small investors. However, unlike some, I am not in the camp that blames the correction on algorithms and machine trading. Perhaps at the extremes program trading could make a downturn worse, but it isn’t the underlying cause of the present correction.

There are numerous other after-the-fact explanations that all beggar the imagination: rising inflation, systematic strategies, the short gamma trade, flattening yield curve, even geopolitics.

My belief is that there are always two factors that are not given enough credit when events like this occur: random chance and mean reversion. Both are powerful, difficult to see and don’t do a lot to fire up the storytelling juices. Neither provides a feeling of satisfaction or causation. But they are more likely the cause than any of the suspiciously satisfying stories we keep hearing.

— For more Bloomberg View columns, visit www.bloomberg.com/view.


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