Perspective on global equity markets through a behavioral finance lens

Accelerating toward mean reversion

Summer 2017

Key takeaways:

  • Momentum-driven rallies tend to be exceptional breeding grounds for behavioral finance biases.
  • The overconfidence bias and the anchoring bias seem to be influencing investor behavior this year.
  • U.S. economic growth has been stable but unexpectedly low amid lackluster inflation and insignificant wage and productivity growth.
  • Elevated valuations are currently factored into stock market prices, in spite of a broad array of challenges.
  • Short-term mean reversion seems likely and could translate into increased volatility, widening credit spreads, and shifts among stock leadership.

This year has certainly been one for the record books. Just past the first eight months in office for President Trump and media headlines still frequently reverberate with controversy concerning his latest statements, comments, and tweets. Similar to how the unprecedented changes in Washington D.C. have evoked a range of sometimes-irrational responses, behavioral finance factors can potentially lead investors to make irrational investment decisions.

The study of how cognitive, emotional, and social factors play a role in the investment decision-making process is the focus of behavioral finance, which I use as the framework for my quarterly investment insights. In this edition of my insights, I discuss two of the behavioral finance biases that we believe have served as catalysts for the equity market's momentum-driven rally this year: the overconfidence bias and the anchoring bias.

Overconfidence and anchoring in perspective

In my recent quarterly insights—"Anchored on campaign promises" and "Confident to a fault"—I touched upon these two biases. The anchoring bias represents the creation of a mental reference point that affects our appraisal of subsequent data and is primarily a cognitive behavioral finance influence. The initial purchase price of a stock, the level of an index on a given day, and economic data as of a particular point in time are examples of potential anchors. Each of these gauges is subject to change over time, with their initial values often of little importance when attempting to gauge subsequent values. The anchoring bias can cause your clients to ignore this reality, potentially leading them to draw valuation conclusions based upon their initial anchors instead of focusing upon the underlying fundamental factors.

Overconfidence is the other behavioral finance bias that seems to be affecting many investors this year. The overconfidence bias is primarily cognitive in nature, but a bias that involves emotional overtones. Overconfidence can potentially cause investors to take inappropriate risks, trade excessively, and overestimate the value of their insights. When this bias is at work, your clients may seem to readily accept evidence that supports their beliefs, while being more likely to reject evidence to that contradicts their viewpoints.

Together, these two behavioral finance biases-overconfidence and anchoring—may have served as catalysts, leading investors to inflate select U.S. stock valuations to what have arguably become stretched levels.

The fallout from momentum-driven markets

Momentum has played a prominent role in U.S. equity markets this year. Confident that President Trump would quickly deliver on a range of pro-growth campaign promises, investors started rotating into cyclical growth stocks during the first and second quarters.

Unfortunately for investors, momentum-driven markets have historically been ideal environments for behavioral biases to arise.

As “animal spirits” increasingly took over, the Dow Jones Industrial Average, the S&P 500® Index®, and the Nasdaq Composite Index all stretched to record highs. The so-called “FANG” stocks—Facebook, Amazon, Netflix, and Google—often led the pack amid the narrowly based, momentum-driven rally. Unfortunately for investors, momentum-driven markets have historically been ideal environments for behavioral biases to arise, as 2017 has demonstrated.

Small-cap stock underperformance

While large-cap U.S. stocks have rallied this year, small-cap stocks have languished by comparison, as demonstrated by the chart below. Slower-than-expected U.S. economic growth amid the limited activation of President Trump's campaign promises can potentially be tied to these results. The president's plans for a major tax overhaul and faster economic growth represented important pillars of his platform, precipitating an impressive rally by small-cap stocks late last year. However, with the president facing an onslaught of political pressures, any potential tax system revisions still unrealized, and political gridlock now in place, small-cap stocks have subsequently underperformed large-caps.

Russell 2000 Index-S&P 500 Index

Surprisingly low market volatility

Other surprises so far this year have been lackluster inflation and wage growth in the U.S., as well as a relative lack of market volatility. In spite of elevated tensions with North Korea, terrorist attacks in the U.K. and Spain, and political unrest in Washington D.C., overall financial market volatility has fallen to extremely low levels. This lack of volatility is reflected in the chart below of the Chicago Board Options Exchange (CBOE) Volatility Index® (VIX®). As shown, volatility has been remarkably well behaved outside of occasional spikes.

The CBOE VIX

Unfortunately, rather than representing a sense of optimism, the lack of volatility may indicate a pervasive sense of complacency and late-cycle bull market fatigue, alongside an increased desensitization to media headlines.

Mean reversion could take over in the short-term, with greater volatility, rising credit spreads, and value and small-cap stocks returning to favor.

If these factors are at work as we suspect, mean reversion could take over in the short-term, with greater volatility, rising credit spreads, and value stocks and small-cap stocks returning to favor. The depreciation of the U.S. dollar in 2017, as shown in the chart below, is another important factor that bears watching. With the dollar depreciating this year, exports should benefit, representing one of the reasons that some analysts expect the Federal Reserve to raise short-term interest rates a final time this year.




U.S. Dollar Strengthened after Election Day

Generational considerations for the current climate

Stocks that have benefited the most from the post-election rally seem particularly at risk in the current environment, and from a generational standpoint, so do baby boomers (1946-64). The values often embraced by boomers include high self-confidence and a willingness to take calculated risks, translating into a greater potential risk of having fallen prey to the overconfidence bias amid the post-election rally. Based on voting data, baby boomers may also be more anchored on expectations that President Trump will deliver on his campaign promises.

Highly social millennials (1980+) seem far more likely than other generations to compare valuations against hard data. As a result, millennials--the largest living generation--seem far less likely to be affected by either the overconfidence bias or the anchoring bias. Generation-X (1965-1980) clients are usually best gauged on an individual basis, given that their investment tendencies can resemble those of boomers and millennials.

On the investment horizon

Looking toward the remainder of 2017, mean reversion appears increasingly possible over the short-term. Although accurately predicting when these often dramatic sentiment shifts will occur is extremely difficult, stretched valuations and the momentum-driven environment suggest that we have begun the final phase of the current bull market. If mean reversion unfolds as we expect, credit spreads could widen and small-cap and value stocks may return to favor.

In addition, plenty of potential market hazards are worth monitoring. On the geopolitical front, the largest obstacle is the increased uncertainty surrounding North Korea. The political gridlock in the U.S. represents another challenge, including upcoming decisions regarding the U.S. debt ceiling and rising possibility of a government shutdown.

With these points in mind, now might be an opportune time to re-evaluate your clients' portfolios. Has the remarkable outperformance of growth-oriented stocks this year unbalanced their asset allocations? If so, consider shifting some of these holdings into other opportunities. Valuations on tech-related stocks recently reached levels last seen in 2001, right before the tech bubble burst. This makes growth-oriented equities particularly vulnerable to any market pullbacks.

Consider evaluating your clients' international market exposure in the process. Emerging and developed equity markets have been bright spots in 2017, a trend that we believe may continue for now. Europe’s political landscape has settled, its economy is recovering, and the European Central Bank’s monetary stimulus is bearing fruit. Meanwhile, emerging markets enter the remainder of this year in a position of strength, benefiting from stable commodity prices, U.S. dollar weakness, and a potential "soft landing" for China's economy.


Omar Aguilar, PhD
Chief Investment Officer, Equities and Multi-Asset Strategies
Charles Schwab Investment Management

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