History doesn’t repeat itself, but it often rhymes.
So said Mark Twain, or possibly someone else, depending on whom you believe.
You might say the same thing about market drawdowns. While next year’s crisis won’t look quite like last year’s, they’ll share some common traits. Hence the rhyming.
Let’s start with the average investor’s “narrative.” In order to make sense of a world that is mind-numbingly complex, we make simplifying assumptions. There are simply too many variables to process at one time. A technology stock analyst, for instance, is unlikely to be an expert in commodities, macroeconomic trends, central bank policy, GDP forecasting and all the dozens of other variables that could affect those stocks. Instead, he or she will assume that other smart people – experts in those areas – are on top of those issues and that this is reflected in market prices. He’ll focus instead on his core competency of, say, predicting revenue and earnings growth.
Market drawdowns are often prompted by a sudden shift in this narrative – when you can’t take those assumptions for granted anymore. Take last June. The widespread view was that China’s growth was a slower but still healthy 7% per annum. This assumption filtered through revenue and earnings forecasts for thousands of companies, commodity prices, macroeconomic policies, etc. A pundit here or there predicted a hard landing, but most had been discredited by wrong (or early) calls and investors had learned to tune them out. Think of it as part of the background fabric behind most investment decisions.
All of the sudden China was center stage. Did the plunge in equities signal a hard landing? A loss of control by China’s bureaucrats? The start of a currency war? A more benign reversal of bubble-like gains earlier in the year? Were trading halts a good or bad sign? Who would be most at risk if growth were to grind to a halt? Investors around the world struggled to get up the learning curve. Many sold first and asked questions later. Market volatility spiked which reinforced the sense of impending doom.
When the narrative is shaken, investors are pulled out of their analytical comfort zones as they tried to understand this new, foreign (literally and figuratively) risk. The tech stock analyst above probably struggled to predict how a potential currency war might cascade through company projections and earnings.
The change in the probability matters more than the magnitude of the downside
New risks like “China” often have two characteristics that feed market volatility: the downside is big and the probability is hard to quantify. To go back to the rhyming metaphor, this was true with Grexit, Ukraine, Ebola and now crude oil. Markets went through very volatile periods as each of these risks moved to center stage.
What’s fascinating is that the change in the probability matters more than the magnitude of the downside. There’s always some probability that a terrible event will happen. Every time I get into my car, I (thankfully) don’t calculate the odds of dying and make a conscious decision that it’s a risk worth taking. I assume it’s zero. The tech analyst doesn’t obsess over a scenario where Silicon Valley is destroyed by an earthquake – round down to zero. Arguably, this is a healthy defense mechanism that enables us to get through the day.
The point for investors is to occasionally remind ourselves of the background narrative. It might help us to be prepared when new risks move to center stage. It also gives us a framework to think about market volatility at the time and, perhaps, to get less caught up in the day to day gyrations of the market or the wild prognostications of market pundits.