9th March 2007
The Malta
On Monday 26 February,
most international equity markets in the world closed at near all-time or many
years’ high. They had last suffered a price correction in May 2006 when they had
continued moving erratically one step forward one step backward for two months.
Since early July 2006 till 26 February, the markets displayed a s
trong one-way
upward move, registering solid double-digit growth on most exchanges without any
serious correction along the way.
The strong run-up was making investors apprehensive. They did not want to leave the party too early but they knew that the market was ripe for a correction even though most agreed that fundamentally, the international equity markets were still reasonably priced given the strength of corporate profitability.
Then in the week between 27 February till last Monday, the market corrected falling more than five per cent and wiping away the profits that had accumulated since the start of 2007.
What causes such sharp volatility on international capital markets? Occasionally this is triggered by an external unexpected event, a major terrorist attack or a market failure by some big player. But this time round there was nothing of the sort and therefore investors are looking for reasons to understand the reason for this sudden reversal in order to help them in deciding whether to exit their position or ride through in the belief that the market will soon recover its sanity.
For those who have been in this business for a long time, such events present more of an opportunity rather than a disaster. Investors who base their decisions on fundamentals remain confident that fundamentals don’t change overnight and the opportunity to buy value at a cheaper price comes only when the quick-buck investors lose their nerve and start dumping value stocks to cut their losses.
So what causes such sharp volatilities on the market? Simply because the market is not composed solely of value Warren Buffet-type investors, on the contrary it is largely populated by bed-and-breakfast investors who try to make a quick buck, often leveraging their position by borrowing to invest more than they have in own money, and relying mostly on market momentum rather than fundamental-value analysis.
Such day-tripper investors often incorrectly price the risk of investing, believing that on their short-term investment horizon the momentum will keep prices moving in the direction they bet on and therefore pay acquisition prices that do not correctly reflect the risk inherent in their investment.
This explains why it is healthy for markets to occasionally adjust their valuations by short, sharp, downward movements to shake off such greedy investors who cannot correctly price the risk they are taking on when investing on a momentum basis.
When markets experience eight months of continued one-way growth as happened since July last year, the market starts attracting such day-tripper investors that increase demand and take market prices higher than they would go pushed by their own organic momentum.
As the market keeps going up, such short-term investors who often would have leveraged their position through borrowing, start getting jittery but hold on to squeeze the last pip out of the lemon.
Ultimately, when profit-taking starts, they will try to liquidate positions to protect profits or cut losses and many investors try to rush out of the narrow door simultaneously.
This exacerbates the correction until such day-trippers are flushed out of the system and until share prices adjust to bargain fundamental-value territory that brings back interest from long-term investors who laugh at the opportunity to buy value at a discount.
The events of the last couple of weeks give a live demonstration of the lesson that the market is a mixture of fundamental-value investors and psychology-driven investors.
Fundamental values do not fluctuate wildly but psychological feelings do fluctuate as people’s perception of risk changes like the weather. This forces inexperienced investors to buy expensively at the peak of positive psychological feelings towards the risk of investing and sell cheaply when the risk appetite falls and the market psychology of risk turns negative.
Fundamental-value investors make money by disregarding the wide swings in psychology moods and buy when market prices correct into bargain territory and ease off their investment positions when prices extend themselves out of fundamental value.
My feeling is that fundamental investors will soon enter the market when they are convinced that day-tripper investors have been squeezed out of the narrow door leaving behind attractive valuation on equity share prices.
The strong run-up was making investors apprehensive. They did not want to leave the party too early but they knew that the market was ripe for a correction even though most agreed that fundamentally, the international equity markets were still reasonably priced given the strength of corporate profitability.
Then in the week between 27 February till last Monday, the market corrected falling more than five per cent and wiping away the profits that had accumulated since the start of 2007.
What causes such sharp volatility on international capital markets? Occasionally this is triggered by an external unexpected event, a major terrorist attack or a market failure by some big player. But this time round there was nothing of the sort and therefore investors are looking for reasons to understand the reason for this sudden reversal in order to help them in deciding whether to exit their position or ride through in the belief that the market will soon recover its sanity.
For those who have been in this business for a long time, such events present more of an opportunity rather than a disaster. Investors who base their decisions on fundamentals remain confident that fundamentals don’t change overnight and the opportunity to buy value at a cheaper price comes only when the quick-buck investors lose their nerve and start dumping value stocks to cut their losses.
So what causes such sharp volatilities on the market? Simply because the market is not composed solely of value Warren Buffet-type investors, on the contrary it is largely populated by bed-and-breakfast investors who try to make a quick buck, often leveraging their position by borrowing to invest more than they have in own money, and relying mostly on market momentum rather than fundamental-value analysis.
Such day-tripper investors often incorrectly price the risk of investing, believing that on their short-term investment horizon the momentum will keep prices moving in the direction they bet on and therefore pay acquisition prices that do not correctly reflect the risk inherent in their investment.
This explains why it is healthy for markets to occasionally adjust their valuations by short, sharp, downward movements to shake off such greedy investors who cannot correctly price the risk they are taking on when investing on a momentum basis.
When markets experience eight months of continued one-way growth as happened since July last year, the market starts attracting such day-tripper investors that increase demand and take market prices higher than they would go pushed by their own organic momentum.
As the market keeps going up, such short-term investors who often would have leveraged their position through borrowing, start getting jittery but hold on to squeeze the last pip out of the lemon.
Ultimately, when profit-taking starts, they will try to liquidate positions to protect profits or cut losses and many investors try to rush out of the narrow door simultaneously.
This exacerbates the correction until such day-trippers are flushed out of the system and until share prices adjust to bargain fundamental-value territory that brings back interest from long-term investors who laugh at the opportunity to buy value at a discount.
The events of the last couple of weeks give a live demonstration of the lesson that the market is a mixture of fundamental-value investors and psychology-driven investors.
Fundamental values do not fluctuate wildly but psychological feelings do fluctuate as people’s perception of risk changes like the weather. This forces inexperienced investors to buy expensively at the peak of positive psychological feelings towards the risk of investing and sell cheaply when the risk appetite falls and the market psychology of risk turns negative.
Fundamental-value investors make money by disregarding the wide swings in psychology moods and buy when market prices correct into bargain territory and ease off their investment positions when prices extend themselves out of fundamental value.
My feeling is that fundamental investors will soon enter the market when they are convinced that day-tripper investors have been squeezed out of the narrow door leaving behind attractive valuation on equity share prices.
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