What’s moving the markets?
Having a market perspective means understanding the set of narratives driving the global financial markets. This is important because understanding the narratives and where they are going can set an investor up for opportunities or steady nerves during periods of uncertainty. But what is a market narrative? To answer this question we begin by understanding what typically drives market behavior.
Investors with a desire to preserve or grow assets are constantly seeking opportunities where the price of their investments either stays the same or moves higher. On any given trading day within a financial market, a steady movement in asset prices is driven by an amalgamation of individual actions.
One investor may enter the market because she heard about an opportunity from a friend. An institutional investor like an insurance company or pension fund may sell one asset in their portfolios and buy another in order to better align with their performance benchmark. Algorithmic trading has also contributed to daily market activity at an increasing pace. These and many other sorts of transactions happen in the financial markets in any given trading day.
This steady flow (or volume) of activity tends to drive modest swings in daily prices. So, what happens when asset prices begin to swing wildly hour-to-hour and day-to-day? It is during these times that something changes in the market narrative. In other words, the story that market participants use to rationalize current trends in the financial markets has been altered and therefore asset prices adjust to meet this new reality.
What do market narratives mean for investors?
We believe that such movements in asset prices can occur for two broad reasons: a) market narratives suddenly change because of an event (catalyst) like geopolitical developments, a change in earnings/economic conditions, or government policies fundamentally alters widely held investor beliefs which then leads to b) market participants anticipating that the current price of an asset is either too expensive or too cheap (valuation) given a recent change in the market narrative.
We believe that investors who can spot these potential catalysts can take advantage of market mispricings by anticipating changes in key narratives and position themselves toward assets with favorable valuations. In other words, if you can figure out how a market story will unfold before the rest of the market does, there is a chance that you can benefit when stocks or bonds move higher or lower.
Market valuations and market narratives
Much has been written about determining the value of an asset or the broader market. In their seminal work, “Security Analysis”, Benjamin Graham and David Dodd lay the foundation for determining the intrinsic or fair value of a company stock. This work was fundamental for investing giants like Warren Buffett by teaching the tenets of value investing (buying stocks on sale). This is what we refer to as the “science” of investing, or rather, being able to take an objective, quantitative look at the value of an asset without being married to our feelings about what an asset should be worth.
A whole industry centered on explaining and teaching these and other important securities analysis concepts has cropped up in recent decades. As a result, investors today have more tools at their disposal which they can use to make informed buying (or selling) decisions without having to do a lot of involved work. Indeed, we believe that what’s paramount to becoming a successful investor is having a solid understanding of an asset’s valuation. In other words, asking whether a potential investment is cheap or expensive. Fortunately, many tools and services help distill this once complicated pursuit into easily digestible market level information, simplifying a key step in the investment decision making process.
The “art” of investing: market narratives
What has yet to gain widespread traction in the investment industry is a systematic approach for quantifying or evaluating potential narrative catalysts that may affect market behavior. Given the recent systemization of valuation work, an investor today can potentially add value to their portfolio not by asking whether a given market is cheap or expensive, but rather what series of events can lead the broader markets to such a conclusion.
Indeed, we think that an investor who spends their time focused on a particular area of the market, recognizes the narrative driving its price action (this is the “art”) and correctly identifies the factors that can influence important turning points in the market can get a leg up on other investors. If nothing else, understanding the market narrative and how it may evolve over time can help make one a more informed and thus a steady investor during periods of heightened market uncertainty.
How to think about market narratives
We categorize market narratives into three distinct groups: individual, narrow and broad. This reflects the evolutionary process that a given narrative may pass through before becoming a catalyst that alters the trajectory of the broader economy. Indeed, we believe that what market participants care most about is the health of the economy and where it is headed. This is because at its core, a security’s valuation is dependent on a firm’s earnings power, or ability of a government to pay back its debts. When the economy is doing well, households tend to spend more, and companies earn more while the government typically collects more taxes to finance its borrowing and spending.
The broad narrative therefore is the story that the markets are telling themselves today about the economy to help rationalize their bullish (or bearish) sentiment. Risk assets may move higher as data reports (like GDP, employment or business and consumer confidence) confirm that main street prospects are rosier, signaling to the markets a potentially brighter earnings environment in the quarters to come. Yet all good times come to an end at some point and a catalyst is what leads the change.
This can happen suddenly as in the case of an unforeseen shock like the events of September 11, 2001. More often, seemingly isolated individual events over time chain together to form a narrow narrative. Depending on the course of events, a narrow narrative can eventually build to the point where its effects are advantageous or deleterious to the economy, a process that can take weeks, months or years to occur. When it does, the narrow narrative becomes the broad market narrative.
Market narrative: Great Recession as an example
The Global Financial Crisis of 2007-2008 ushered in the Great Recession in the U.S. and led to one of the greatest financial market selloffs in history. The broad narrative during the height of the crisis was the risk that the financial system in the U.S. and globally could come to a halt as a result of credit and borrowing issues in the global economy. Indeed, investors quickly exited risk assets as banks folded, key lending institutions went into conservatorship and the U.S. government orchestrated unprecedented bailouts of private companies.
These events, however, didn’t happen overnight or come from nowhere. To be sure, subprime mortgage lending, and the excesses that evolved out of this bank lending behavior help precipitate the crisis. A paper from the Federal Reserve Bank of Saint Louis illustrates that the roots of subprime lending began in the early 2000’s. Falling borrowing rates, a government mandate for home ownership and lax regulatory oversight enabled a rapid increase in shady bank lending activity. Isolated actions of banks (individual narrative) over the years turned into an industry norm which helped to push up property prices, at the same time leading to a fundamental change in the credit derivatives markets.
Before its unceremonious fall in 2008, Countrywide Financial was one of the most notable subprime mortgage lenders in the U.S. While one of the biggest and most visible contributors to the financial crisis, Countrywide was not alone in its contribution to the demise of the housing and lending markets. Other lenders like Washington Mutual and Golden West were simply partaking in behavior that had become a norm in the industry, the seeds of which were planted years earlier. This activity contributed to a “narrow narrative” that spawned the rise of collateralized debt obligations that would eventually lead to insurance company AIG’s need for a government rescue.
By late 2007 the broad market narrative had evolved from euphoria over the booming housing market to that of growing concern about the financial sector and worries of a looming U.S. recession. This broad narrative was influenced by narrow narratives in the housing market which evolved from the individual narratives of lending decisions made by many smaller lenders just years before.
News headlines and market narratives
Given the complexity of the world around us, how do we piece through and keep track of individual, narrow and broad market narratives? These narratives typically come to us through the news on a daily basis. Behind these news stories are reporters and producers, human beings, looking to break the next story or add a unique spin to the current narrative.
There are many award-winning reporters who are known for their diligent, ground breaking research. Take Financial Times reporter Gillian Tett, who in 2007 reported on a breakdown in the global credit markets resulting from the rise of collateralized debt obligations and credit default swaps. These are some of the instruments that contributed to the systemic issues that led to the global financial crisis and Great Recession.
Budget cuts over the years have nevertheless meant fewer reporting staff, putting more pressure on reporters to produce fresh ideas and relevant content at a higher throughput. So where do reporters get their ideas? Often from their contacts in the investment industry. Every week hundreds of research reports are generated by the investment industry that make their way into reporters’ hands. If a reporter or producer finds the content relevant, they will contact the author for an interview which is often used in an upcoming story the reporter is writing.
Industry research helps form the narrative
What’s the point here? Often the stories we read in the news are influenced by individual industry insiders who report the views on what they’re seeing as important to the markets and only to select audiences. Reporters tapped into this pipeline help to connect the dots between unique views shared by industry leading market watchers and participants and then disseminating these views to the public at large. So, while a narrative may be crafted by reporter, key points in their narrative are often influenced by industry insiders. Often, this is how we get a bead on what the markets or what the “smart money” may be thinking.
Investors looking to take a more hands on approach can augment this headline view of the market narrative by supplementing it with their own investigative work. Mutual funds, wire houses and industry groups publish market research that diligent investors can track down on the internet and use to flesh out the market narrative. Newsletters, blogs and social media are also useful sources of information in these efforts. The point here is to not get bogged down by any one view over another. Rather, take the whole of the views and find commonalities with the market narrative and more importantly, the differences to help craft individual, narrow and broad narratives.
What does FMA|Perspectives do differently?
Ned Davis, founder of independent investment research firm Ned David Research was driven by the notion of making money over being right. In fact, this very point was the title of his book, “Being right or making money”. In his work, Ned points out that you can have a general sense for the value of an asset. What really matters, however, is what the market is willing to pay for an asset and not necessarily what an individual investor thinks it’s worth. Therefore, understanding where the market is going (and why) can help an investor get ahead or avoid costly mistakes in their portfolio.
At FMA|Perspectives our goal is to categorize, synthesize and interpret the market narratives at their various levels and connect the dots back to what it may mean for investors. At the end of the day what we believe to be important is not what we think should happen in the markets, but rather what financial markets might expect to happen to a given narrative in the weeks, months and years ahead.