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Markets are highly volatile at present, with investors swinging between optimism and pessimism on the economic outlook, and pulling asset prices with them. Each new piece of good or bad news brings sharp fluctuations.
Asset prices are determined not only by fundamentals, but also by investor sentiment. So just how critical is sentiment in these febrile days? What will it take to settle investors’ nerves? And what does all this mean for investment strategies?
Colin McLean, managing director at SVM Asset Management and former chairman of the UK’s Society of Investment Professionals, is an expert in investor behaviour. He answers your questions below.
Is there such a thing as a fundamental, or an inherent value to an asset, that exists regardless of sentiment and expectation?
Richard Holdcroft, Hong Kong
Colin McLean: I side with the academics who question this. The idea that everyone processes information in the same way or uses the same methods for valuation seems questionable. Some research now suggests that an equilibrium price might only be achieved by a stock in the long term, with issues such as liquidity and sentiment the main short term drivers. Too many investors who rely on underlying value seem to focus on measures like book value and dividend yield which may prove transient.
I think it is sensible to have in mind that only a trade value can be a realistic underpinning for valuation. It will take a pattern of bids and deals to establish that stock prices might have fallen too far.
Is institutional money less prone to fickle mood swings than private investors? Does the distinction even matter, as the greater fool and beauty contest theories posit that underlying fundamentals are less important than market perception?
Gerald Fabrot, Brussels
Colin McLean: I believe that institutions can suffer from the same behavioural failings as private investors. Indeed, their organisation into teams and the interaction between professionals, can cause additional problems. Group dynamics can make team decisions quite inflexible in bear markets, where an individual may be better able to adapt to a different economic environment.
In the short term, perception is certainly important, and very sharp rallies are a typical feature of bear markets. However I do not think that private investors or institutions can readily profit from this volatility. They are more likely to be caught up in the swings of sentiment. Private investors should try to maintain a more stable strategy through the volatility and take advantage of the fact that they are less likely to suffer from the overconfidence shown by many professionals and experts.
How is the uncertainty in the macro outlook, combined with a trend toward flexible asset management mandates (i.e. proliferation of 130/30 products), affecting the day-to-day practice of shorting stocks? Does investor sentiment have a greater impact on these activities as a result?
Nathan Peters, London
Colin McLean: I do not believe that 130/30 funds are yet making a big impact in the UK, but there are more equity long/short funds now operating than in the last bear market. In the US, 130/30 funds have been mainly quantitative and found markets difficult.
The greater level of shorting is creating more volatility and I think the sharp rally in many stocks in late January and the first two days of February was driven largely by short closing. Many funds now involved in shorting have been set up only since the 2000 to 2002 bear market. I think that the volatility during this period of short covering will encourage more hedge funds to focus on taking only positions in futures or sector baskets in the short side, and reducing individual stock shorting. Risk limits on short positions mean that covering can be forced as soon as a stock has moved, say, 10%, exacerbating volatility. That seems a stronger effect than sentiment.
Panic and desperation are sentiments indicating the bottom of a stock market crisis – and the moment to start buying value stocks. Which is the best indicator of sentiment to forecast that we are at the lowest possible point of the cycle?
Nicolas R, Spain
Colin McLean: Some indicators of the top of a bull market, like employment, lag in calling the recovery. Usually the bottom is marked by anecdotal evidence from companies that their markets have stopped getting worse, or they are managing to cope with conditions. Sectors will bottom out at different stages, and I think it is best to look at each fundamentally rather than looking at economic or sentiment indicators. Crucial to this recovery will be inter-bank lending and dividend cuts, and I am looking for those.
Is there any evidence that UK private investors have sold assets indiscriminately during the recent market dislocations? When was the last time private investors did sell indiscriminately? What would it take to cause a panic now?
Alex Erskine, Sydney
Colin McLean: There has been surprisingly little real capitulation yet by investors, given the easy credit and excesses of the past four years. Some hedge funds appear to have had forced liquidations of positions, but I do not think we are yet at the stage where fear predominates.
In 2002, there were some extreme sell-offs. Investors sell when they think they will always be able to buy back lower, or when they have lost faith in all the valuation metrics. To an extent, metrics like dividend yield have failed in recent months to support stocks. Further bad news on bank losses that is difficult to quantify could trigger a further sell-off with little regard for conventional valuation metrics.
Most academic theorists caution against trading on sentiment but humans are not just rational beings, but also subject to emotion. Considering that the run up in the markets was attributed to exuberance, what should we expect from the current bipolar mood?
Judy JL Yeo, Singapore
Colin McLean: Research in behavioural finance points to the tendency of some investors to view trading as entertainment, and also to wrongly associate their gains in bull markets with a high level of trading activity. Not surprisingly, losing money in bear markets is less entertaining and leads to a decline in market activity.
In falling markets, investors have greater anxiety, and this recognition of the potential for losses actually leads to more realistic and rational behaviour. I do not think that investors currently have a bipolar mood, but markets are torn between competing views. I believe that investors that show more anxiety and realism about current economic conditions will prevail.
If you had to form an investment decision given fundamental, technical, quantitative or economic analysis, which would you put most weight on?
Richard Bayley, London
Colin McLean: I think that economic analysis is less helpful - generally we must buy companies and not countries, and economic data lags. Fundamental approaches are useful where accounting standards and disclosure are good, but in a downturn company information can become unreliable. I believe that quantitative approaches have been much less useful over the past 12 months, and I do not have the faith in the capital asset pricing model that they rely on. In a bear market, driven by liquidity needs, technical analysis can be particularly helpful, and I believe it has outperformed the other methods over the past year. It should point to the turn in sentiment when the bottom is reached, before fundamental data has captured that.
Since you are an expert in investor behaviour you must be extremely wealthy. Are you? And why are you sharing the secret?
Colin McLean: Some newspapers seem better able to value my assets each year than I am! My best results have been in portfolios such as my pension fund where I have not sold a share for many years. I think that all of us have something to learn from behavioural finance, and I do think that investment management may need only a few good long term decisions, combined with patience.
While most asset prices are backed by either explicit promises to pay, or implicit promises of earnings streams, gold (and other precious) metals seem a rather quixotic asset class that is largely sentiment driven. Where do you think the current complex of investor sentiment is likely to drive gold prices in 2008?
Mohit Satyanand, New Delhi, India
Colin McLean: I am a bull on gold, and have more than 10% of my portfolios in gold miners. Gold can generate a return if it is lent, and so I do not believe it fundamentally differs from other asset classes. At present, easy monetary policy appears the only solution the US has to offer, and I believe that strength in the gold price will reflect the potential for currency debasement.
Do you think modern technical analysis approaches may help to minimise the influence of investor sentiment on the definition of investment strategies?
Viktor O Ledenyov, Ukraine
Colin McLean: I believe that technical analysis can be more helpful than fundamental methods in markets that are driven by liquidity needs. I think that more attention is currently being paid by many professionals to technical indicators. As more look at the same indicators, there is a risk that technical analysis leads to more investors behaving similarly. However, technical indicators should also capture the basing of sentiment that happens at the market bottom.