We speak of strategies like perhaps this is a good time to be invested in emerging markets, Latin America or perhaps China or maybe even the BRICs, typically by means of spdrs, ADRs, mutual funds, ETFs or the like. Often these strategies are considered defensive plays where there is a lack of confidence in U.S. companies, the economy or the stock market, but good confidence in what is developing elsewhere. The problem is too often this approach does not work, at least in the short term. Why? Because the market on a downward tear, for example, takes just about everything with it, except maybe gold and a few similar picks. A downward tear seems more likely these days, if Friday, October 30th, is any indication, when the DOW dropped by almost 250 points and the NASDAQ, by over 52.
Although Brazil may be on a terrific upswing, BRF and EWZ will sink or drop along with everything else. That China is trending up doesn´t matter; your Chinese GXC and FXI will tank along with the rest of the market. Ditto for emerging market funds such as ESR and EWX. Your BRIC fund BIK will sink like one. The market takes the good, the improving and everything else all down together when it is dropping quickly. Why? I think simply because they are there and in the same market. A collective herd mentality indiscriminately takes hold. Buyers and sellers react emotionally and do not discriminate.The good sink with the bad and the over-priced. The drop is not about individual funds or stocks; it is about what the market itself is doing and participants getting out of it.That things might well sort themselves out much further down the road is little consolation for the adversities and losses in the here and now.
Several years ago, before the Great Recession, but after problems in the world economy began to emerge, The Economist Magazine attracted much attention by arguing that the emerging markets were no longer closely coupled or tied to American and European markets. The emerging markets had "decoupled" and now had independence and freedom of movement, we were told. I was skeptical, as were others at the time. The financial collapse of the Great Recession made it quite clear how wrong the Economist Magazine was, at least in regard to financial markets. Indeed, world financial markets are closely tied together.
It was an example of what economists jokingly refer to as Walras’ third law: ‘everything is related to everything else.’ America sneezes and Ecuador catches a cold. So perhaps the good sinking with the bad or over-priced is not just a stock market phenomenon, but a larger real or financial one as well, at least to an extent. But again, in a market on a downward tear, is this the market’s prescience, or simply a friction or vacuum effect of being along side? I suspect the latter. It is kind of like being financially rear-ended.
This phenomenon has several untoward consequences, generally. First, it makes it harder to determine what a good stock, mutual fund or ETF pick is, at least short term, by looking at price performance. This is because performance gets separated from the company’s or fund’s fundamentals in a strongly trending market. Secondly, it is hard on the truly good picks. Instead of basking in their earned glory with rising prices, they sink with the market trend and the bad and over-priced apples. Thirdly, depending on your internal rate of discount, even if your careful picks will do better in the longer run and stand out then, the beating you can take in the short run by having them move with a downward trend can be prohibitive. These facts, in turn, themselves have significant consequences for the market.
What we observe is why many players in the market are much more concerned about going long with the trend if it rises and short with the trend if it drops, rather than in picking good solid stocks, funds and ETFs. Playing the trend and believing the trend is your friend are nothing new. You can aggressively go after trying to pick the turning points or like old J.P. Morgan (JPM), you can sit back and take your bite out of the middle. There are many kinds of trend players and many time frames within which to play trends. The argument is you don’t care how good your picks might really be on a Value Line or Graham & Dodd basis, because if you fight the market, using those selection criteria, you can get clobbered. If you go with the trend, even riding picks that are known dogs, you can make money. Quirky, but true. In this case, a changing tide lifts or lowers all boats, even those about to sink.
The problem is that the net result of these developments, if too many market participants become trend players instead of investors, is the market begins to look more like a casino and it more readily disconnects from the real economy and the companies whose stocks are involved. It becomes less and less like a forum for good secondary investment, according to time honored investment principles. Herd behavior, band wagon effects, manipulation and the like are able to generate increasing instability in such stock markets. Such increased volatility is viewed opportunistically by traders playing the trends, even if they are only daily ones. At the same time, stock markets become more amenable to bubbles and their consequences. The market incentives to participants have become non-optimal.
These are not developments we should like to see. They reflect on the health of the market as a market per se. They leave us few safe havens in the event of a down pour. They can waste or compromise a lot of good work on careful stock or fund selection and they can send mixed signals to IPO and secondary offering markets. These matters go far to keep money market funds in business and brokerage cash accounts active and busy. But what are reasonable market participants to do?
Disclosure: no relevant positions
