Even though we are on the precipice of a potential all-out war in the Middle East, which could cause a major oil price shock and trigger global recessions, US stock valuation ratios are near all-time highs, and implied equity risk premiums are near all-time lows.
There is a long history of financial markets mispricing major macroeconomic risks. Historically, market prices have tended to adjust downward to major macroeconomic risks only long after the crisis-causing problems were apparent to objective observers.
In this article, we explore why markets tend to react late to major macroeconomic risks. These issues are discussed in even greater detail in the video embedded below this article.
Markets Are Not Rational Actors
When faced with a major macroeconomic risk, a rational actor would discount prices per an “expected return” calculation. The potential drawdown caused by the realization of a major macro event would be multiplied times the estimated probability of the event occurring. The problem is that the prices reflected in markets are not arrived at through such a procedure.
Market prices reflect the opinions and emotions of a marginal buyer and a marginal seller. We know that all investors evaluate risks differently and they even evaluate risks differently at different times. To understand what sort of risks are being accounted for in market prices one needs to understand who the marginal buyers and sellers are and what their tendencies are concerning the evaluation of risks at that particular time.
Age-Old Tendencies That Are With Us Today
In the late stage of a bull market cycle, two age-old tendencies tend to severely impact the assessments of risk by marginal buyers and sellers.
The first tendency can be described as irrational exuberance. Robert Shiller won a Nobel prize, in part, by describing a behavioral tendency whereby market mispricings are formed late in a bull market as a result of overly optimistic narratives, which tend to exaggerate positive outcomes and disregard major risks.
A second tendency can be described by the term FOMO — fear of missing out. Late in a bull market, prices have been rising spectacularly and investors have been enjoying extraordinary price gains – despite the presence of various risks. Under these circumstances, owners of stock do not want to sell for fear of missing out on further gains.
At the same time, those who are currently underinvested (or feel like they are) feel compelled to buy stocks at almost any price for fear of missing out. In this regard, the behavior of institutional investors is particularly important, since under-performance during a bull market can lead a fund manager to lose their job. Due to fear of missing out on a continued rally — a situation which could cost them their job —fund managers will buy stocks, even though they know that stocks are overvalued and risks are high.
Another factor that comes into play could be called “the boy who cried wolf”. In the latter stages of a bear market, there will already have been various instances in which feared outcomes did not materialize. Whereas such fears were discounted earlier in the bull market (because memories of the most recent bear market are relatively fresh), they tend to be ignored late in a bull market.
This is because traders and investors were burned early in the bull market cycle when they overly discounted risks that did not materialize. Therefore, due to the “boy that cried wolf effect”, during advanced stages of a bull market, marginal buyers and sellers tend to be overly desensitized to major risks.
Recent Tendencies Negatively Impacting Market Efficiency
One of the most important market developments in recent years is the increasing growth of value-insensitive and risk-insensitive investing and trading. Indeed, daily traded volume in today’s markets is increasingly dominated by traders and investors that are almost completely insensitive to value and risk.
The first major group of value-insensitive and risk-insensitive investors that has grown tremendously are so-called” passive investors.” Passive investors buy stocks and stubbornly hold them, regardless of how high the valuations are, and regardless of what sorts of risks are present in the market. Passive investors now outnumber active investors. It is therefore not a surprise that markets have become increasingly insensitive to value and to risk.
The second major group of value-insensitive and risk-insensitive investors and traders are so-called algorithmic traders. The vast majority of algorithmic trading signals are based on momentum and other technical indicators. In these algorithms, considerations of value and risk are completely irrelevant. For example, these algorithms are not designed to take into account complex macroeconomic risks. As daily traded volume is increasingly dominated by algorithmic traders, market prices have necessarily become more insensitive to fundamental risks.
The Current Opportunity
The current market insensitivity to risk is very evident. Despite the extremely high risk of a major macroeconomic shock (due to a potential oil price shock), valuations are near all-time highs and implied equity risk premiums are near all-time lows.
This insensitivity to risk, caused by the factors described above, is currently providing active investors and value-sensitive investors with an exceptional opportunity. As discussed in greater detail in this video, there are numerous ways in which investors can seek to take advantage of the current mispricing of risk.
The most conservative option is to simply raise cash positions to be able to take advantage if market prices decline significantly. Another strategy is to look for investments that are likely to perform well under the forecast set of specific circumstances. In this case, stocks in the energy sector should be looked at closely. Another strategy is to make outright bearish bets – e.g. via short sales or option strategies – on vulnerable stocks, and/or indices.
Conclusion
The fact that the market is mispricing the probability of certain events materializing does not necessarily imply that the associated risks will materialize. However, over time, investors who can identify mispricings of macro risks that can generate asymmetric reward-to-risk profiles can be richly rewarded through the implementation of smart investments and wise portfolio strategies. We strongly suggest that investors take stock of the current set of macroeconomic risks and adjust their investment strategies accordingly.