Posted by on Jan 11, 2016 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  4:57 pm ET  Jan. 8, 2016

How many surprises can one week in the markets hold?

Twice this past week, China’s stock market dropped 7% in a single day. Three times this week, the Dow Jones Industrial Average sank at least 300 points during the trading day. And then on Friday, the latest employment report shocked almost everyone, as the economy added 292,000 jobs in December — nearly 40% above what analysts had predicted.

To stick to your long-term investing plan, it’s important to understand what surprises do to your thinking.

All investors have a narrative in their head, a set of facts and beliefs they select to make sense of the world. The simpler that story is, the more likely you are to feel you are in control and the more confident you will be that your investment decisions are sound.

But when a simple story is refuted by new facts, your sense of control can be shattered. That can lead to a sudden fear of the unknown.

The human brain is an exquisitely adaptive mechanism that tends to tune out gradual changes, downshifting its activity as the expected comes to pass and familiar patterns repeat. But sudden changes set off the alarm bells of the unexpected.

Neuroscientists have found that specialized cells in a region of the brain called the anterior cingulate cortex respond to unexpected outcomes in as little as three-tenths of a second, firing out warning signals to other parts of your brain that control your pulse, blood pressure and stress hormones — putting your body on almost instant alert.

That helps explain why the collective mood of investors can shift so quickly — as it has ever since the dawn of modern markets in 1719 and 1720, when stocks in London, Paris and Amsterdam levitated together and then crashed in lockstep.

“Metaphors and stories are important in investors’ thinking, and they can become a self-fulfilling prophecy,” says Robert Shiller, a finance professor at Yale University who has studied centuries’ worth of booms and busts. Investors adjust their stories, he says, partly “by the almost instinctive urge to look at others’ emotions.”

Investors had long believed that Chinese economic policy makers were all but infallible — and that narrative helped sustain financial confidence around the world. But the Chinese government’s inconsistent fumbling as it tried to prop up local stock markets has turned that story upside down almost instantly.

“You’re seeing some real body blows to this narrative of competence,” says W. Ben Hunt, chief risk officer at Houston-based Salient Partners, an investment firm that manages $15 billion. “And that is the one thing that a one-party state cannot allow. They have to do something.”

Surprise thus plants the seeds for further surprises.

One possibility, says Mr. Hunt, would be for China to devalue its currency, the yuan, by 10% or 15% overnight. “That’s the sort of shock-and-awe move,” he says, “that could restore a floor under the Chinese stock market and enable the politicians to reclaim the mantle of competence.”

There is long historical precedent for such a sudden move: When governments don’t reduce the value of overpriced currencies, markets do it for them.

In 1720, when the financier John Law gave up his efforts to stabilize the price of the Mississippi Co., the quasi-governmental firm he had set up to support the French national debt, the value of the French franc collapsed on international currency markets.

“His was the first effort to micromanage financial markets, and he came to grief,” says Larry Neal, a financial historian at the University of Illinois and author of A Concise History of International Finance.

More recently, the Bank of England backed away from propping up the British pound in 1992 after hedge-fund manager George Soros drove its value down. Similar struggles over currency have occurred in Latin America and Southeast Asia.

Even if the Chinese government doesn’t pull off a surprise devaluation, it may have to do something dramatic to reverse the narrative that it is losing control over markets.

Investors shouldn’t panic over this imponderable. But even after the recent declines, markets offer little margin for error. The average stock on the Shenzhen Stock Exchange is trading at 45.4 times earnings, or two-and-a-half times the price/earnings ratio on the MSCI All-Countries World Index. U.S. stocks, meanwhile, remain considerably more expensive than their long-term average.

With prices already elevated and investors on edge, positive surprises are likely to lead to small gains at best, with negative surprises setting off much larger losses — as we saw this week, when the worries about China hammered global markets but the good news about U.S. employment barely kept stocks from plunging again.

That’s the opposite pattern from how markets behave earlier in bull markets, when just about any positive news can send stocks soaring. To be a long-term investor means bracing yourself for the possibility of even more short-term shocks than usual.


Source: The Wall Street Journal