Perspective on global equity markets through a behavioral finance lens

Don't get trampled by the herd!

January 2016

Key takeaways:

  • With central bank policies set to diverge, volatility, credit spreads, and market overreactions may continue to distract investors in 2016.
  • We believe some stock sectors could weather the environment better than others in 2016, and that discounting a few growth—oriented areas of the market could turn out to be a mistake.
  • Even for investment professionals, herd behavior can be intrinsically compelling, helping to illustrate why it’s important to pay more attention to a company’s underlying fundamentals than market noise.

Are financial markets always efficient and rational, as Classical Finance Theory suggests? In a perfect world, business cycles and financial markets would evolve in efficient, sensible, and orderly fashion. However, market rallies and selloffs have not always reflected either underlying fundamentals or economically rational behavior.

Behavioral finance—a relatively new field of study—seeks to account for the emotional and psychological effects of human nature on investment decisions. In essence, this field attempts to understand how our natural human tendencies lead us to behave, even when such behavior contradicts what might be a better economic choice.

In my quarterly series of insights, I’ll discuss the equity market’s movements from a behavioral finance perspective, and explain some of the many ways in which human nature can influence our day-to-day investment decisions. To begin the series, I explain "herd behavior"—a central topic in behavioral finance—and how it was displayed in 2015, as well as what we could experience in 2016.

2015 Review: Stampede in China

Herd behavior speaks to the heart of behavioral finance. History is paved with examples of this concept, which is also known as "momentum investing", the effects of which can cause us to chase financial markets sharply higher or lower based upon intuitive shortcuts that overwhelm economic evidence to the contrary. Such behavior can represent a desire to align actions with peers, reflecting what some researchers consider to be typical human behaviors, such as greed, feeling left out, and betting on winners.

Remember the dot-com bubble? At the turn of this century, any new company centered on an internet-related business model with a ".com" after its name seemed destined to catapult its shareholders to millionaire status overnight. This led to a surge of initial public offerings for companies that were sometimes years away from generating economic profits. However, like so many other unsustainable market bubbles, the dot-com craze eventually came to an abrupt halt, as shown by the performance of the tech-laden Nasdaq Composite Index in the following chart.

Was the tech bubble a one-time aberration? Fast forward to 2015, and the answer to that question is a resounding no.

Was the tech bubble a one-time aberration? Fast forward to 2015, and the answer to that question is a resounding no. Financial market trends during much of the past year included: a strong U.S. dollar, lower commodities prices, record-low global bond yields, and positive returns for many developed equity markets. By comparison, most emerging markets faced headwinds, with one notable exception: China. Unlike other emerging markets, equity indices in China repeatedly stretched to one record high after another early in 2015. However, as you can extrapolate, Chinese equities eventually endured a correctional fate similar to that of the dot-com bubble.

As illustrated by the chart below, China’s benchmark Shenzhen Composite Index followed a pattern that was quite similar to that of the Nasdaq Composite Index, surging late in its bull market cycle, but ultimately tumbling due to unsustainable momentum.

However, China’s market collapse was driven by distinctly different factors than those that popped the dot-com bubble. Real estate prices in China started slipping a few years ago, leading millions of mainland Chinese investors to purchase shares of local companies in search of higher returns. At the same time, China’s economic growth began to decelerate amid slower economic activity in developed markets around the world. In addition, increased economic stimulus by the Bank of Japan and the European Central Bank translated into the depreciation of the euro and yen. This exerted downward pressure on Chinese exports and the renminbi at an unfortunate time for China, the world’s second largest economy. Meanwhile, in the U.S., the Federal Reserve (the Fed) was winding down its third quantitative easing program, sparking sharp declines among emerging markets and adding to the undertow for Chinese stocks. Reality finally asserted itself in June 2015, causing the country’s stock market to plummet and erase trillions of dollars in capital. Although slowing demand for U.S. goods by China created few direct repercussions for the U.S. economy, the impact of the turmoil on U.S. financial markets was pronounced.

Herd behavior had taken over. In this instance, investors had been distracted by developments in China, resulting in sharp stock market declines in the U.S. that occurred in spite of generally improving economic fundamentals. The fallout from China’s stock market turmoil also helped to convince the Fed to postpone its anticipated September “liftoff” for raising short-term interest rates. This fueled a dramatic reversal of many main trends that had driven the markets earlier in 2015, while volatility spiked. As illustrated by the chart above, from the start of 2014 until the Fed’s decision to hold rates steady in mid-September, the Chicago Board Options Exchange (CBOE) Volatility Index® (VIX®)—a widely followed gauge of U.S. stock market volatility—averaged 14.5. However, following the Fed’s announcement, the markets remained highly volatile for weeks. As a result, the CBOE VIX averaged 19.9 from the Fed’s post-meeting announcement through mid-December 2015.

Herd behavior had taken over. In this instance, investors had been distracted by developments in China, resulting in sharp stock market declines in the U.S....

2016 Outlook: Increased volatility and central bank divergence

The current air of uncertainty, both in the U.S. and internationally, makes "herd behavior" an important consideration heading into the New Year. In spite of early expectations to the contrary, the federal funds rate target—which sets the floor for a wide range of U.S. interest rates from savings accounts to mortgages—remained near zero percent far longer than many had predicted. As a result, financial markets were fixated on U.S. economic data until December, when the Fed raised short-term interest rates for the first time in more than a decade. In addition, China isn’t the only emerging market facing challenges. Brazil’s economy is being weighed down by a sharp drop in commodities prices. Volatility, credit spreads, and potential market overreactions may continue to distract investors in 2016. This volatility is likely to be exacerbated by potentially divergent monetary policies in the U.S. compared with many developed, international and emerging market economies, which seems likely to have repercussions for both foreign exchange markets and international equities.

From a sector standpoint in the U.S., a trend toward value has been reemerging. Late in 2015, equity markets paused while attempting to adjust to the backdrop of uncertainty amid the low-yield environment, combined with the Fed’s surprise decision in September to keep short-term interest rates near zero percent. For the moment, growth- and momentum-oriented stocks have somewhat fallen out of favor, while dividend-related strategies have rotated back into favor. Telecommunications and Utilities stocks have been substantial beneficiaries of this sentiment shift and could potentially continue to perform well in the short-run.

However, discounting some growth-oriented areas of the market might be a mistake. We think that select Consumer Discretionary and Information Technology stocks could perform particularly well as investors consider where the U.S. economy appears to be headed. In addition, for financial firms that have managed to stay afloat in the prolonged low interest-rate environment, profit margins and overall business models should improve once the Fed starts to "normalize" rates.

Don’t get trampled by the herd!

Even for investment professionals, herd behavior can be intrinsically compelling. However, there are disciplined steps that can and should be taken to help ensure that this instinct doesn’t supersede carefully engineered investment plans. This is an especially important consideration whenever the markets turn volatile, as we experienced during the first week of the New Year. Ask yourself whether a company’s overall financial health has actually shifted, or whether the market is simply rallying or selling off based on irrational market momentum. From our perspective, these will be important considerations in 2016, a year that may face temporary market challenges that could prove difficult to ignore, especially if you’re paying more attention to short-term market noise than to a company’s underlying fundamentals. As the Fed assesses how quickly to shift its policies, uncertainty and increased market volatility seem likely amid speculation regarding how much and how quickly interest rates will rise. Internationally, developed and emerging markets may need to grapple with the economic effects of higher short-term interest rates in the U.S. If so, this could lead to dollar strength versus select currencies, while placing downward pressure on global commodities prices.

Omar Aguilar, PhD
Chief Investment Officer, Equities
Charles Schwab Investment Management
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