Colas - The Random Walk Of Shame

ConvergEx
Nicholas Colas

Today we compare two competing frameworks for understanding market behavior: the “Random Walk hypothesis” and the “House money effect”.  The first states that markets move in random patterns, with prior activity having no bearing on future price action.  The latter shows that individuals do actually consider prior gains and losses when making economic decisions.  That dichotomy is useful in parsing out the recent flurry of volatility. Investors are clearly in a bit of a no-man’s land of market narrative, with the dollar weakening and U.S. corporate earnings slipping.  Market participants, like all pack animals, appreciate clear direction and leadership – and we don’t have much of either right now. On the plus side, investors have a lot of “House money” built up after half a decade (or more) of gains. They can therefore mentally afford some losses. Bottom line: yes, there are choppier markets ahead until the storylines clear (especially regarding the U.S. economy).  But it would take a real shock to dislodge fundamentally bullish risk appetites.  It’s still the house’s money, after all.

Years ago, I worked for one of the best ‘Tape readers’ on Wall Street.  He could – and presumably still can – determine market sentiment and direction the same way mere mortals see a red light turning green.  It didn’t matter if it were a single stock or the market as whole.  His ability was uncanny, but he also knew his limitations.  He was often early by a few hours.  And on a trading desk, that can feel like years.

One day, set up very short for a Fed meeting, things weren’t going his way.  The market was ripping higher and at 11:00am he was down several million dollars. What did he do? He called his wife and had her bring in the family for lunch at the cafeteria downstairs.  I saw him at about 12:30pm, sullenly dipping food service fish sticks into tartar sauce as his children happily munched on theirs.  He reappeared on the desk at 1:30pm, down even more than when he went to lunch.

The Fed did their thing at 2pm, and markets ground higher.  We all held our breath.  The entire room was short as well.  Then, around 3pm, the futures turned.  Hard, and lower.  Much lower.  It was as if someone had pulled the plug on a very large tub of water.  By the end of the day, markets were off 1% and my guy was up over ten million dollars.  At 4:01pm he stood up and said (to no one, and everyone), “That’s how you do it, boys”.  We gave him a standing ovation as he walked out for the day.

I haven’t believed that markets are unpredictable since that day.  Hard to call, yes.  Humbling?  Certainly.  Impossible?  No.  I saw it done, not just on one day but day after day and week after week.  And, I might add, by anyone’s definition: legally.

Not that it should happen the way I’ve just described.  One of the bedrock notions in modern finance is the “Random Walk Hypothesis”, which essentially says that every day is a new one.  Markets are like Buddhist monks in this paradigm, waking up with nothing and taking their begging bowl into the streets to see what fate brings. If markets are up 5 days in a row, the sixth day may be up or down in line with long term trends.  And long term here means the life span of a Galapagos Island tortoise.

After +6 years of a bull market in U.S. stocks, it’s hard to remember about “Random Walks”, but another market paradigm can help fill the void – something called the “House Money Effect”.  This is newer than the “Random Walk”, which was popularized by Burton Malkiel in his 1973 book “A Random Walk down Wall Street”. The seminal work on “House Money” is a 1990 paper by Richard Thaler and Eric Johnson, and it showed that gamblers change their attitude to risk based on prior wins and losses.  Get on a winning streak, and you bet more heavily since you are playing with the “House’s money”.  Hit a bit of hard luck and you pull in your horns (except when given the chance to break even, when you grasp at any passing chance).  It shouldn’t work that way – every spin of the proverbial wheel has its own independent outcome – but in practice the “House Money Effect” is measurable.

If there is one single argument for why investors have stuck with risk assets like U.S. stocks this year, the “House Money Effect” is as good as any. After all, the domestic economy has slowed and not even the Federal Reserve is sure whether that is seasonal, secular, or the result of lousy measurement tools.  Corporate earnings haven’t matched those of a year ago.  And U.S. stocks are not cheap by any objective measure.  Yet, after a long run of gains, it’s the house money on the table.  And we know that’s more risk-prone capital than what investors may consider their own.  That also explains the remarkably low levels of both actual price volatility and the CBOE VIX Index. The VIX close today of 14.6 is still one standard deviation away from the long run average of 20, even after all the stress of the day.

It has suddenly become fashionable to call the recent volatility the start of a broader correction for U.S. stocks. Somehow 5% is the benchmark level for such a move, presumably because the human hand has 5 fingers.  If dogs traded stocks, 4% might be the level.  For octopi traders, it might be 8%...

The point is that the percentage move matters less than how we get there, if you use the House Money paradigm. A one-day 5% move would leave investors wondering if the next day would bring another.  That would likely be enough to shift risk appetites and cause a broader sell off.  A grind lower for a month might not, especially since there would no doubt be some random-walking positive days to give investors hope.

The hardest single issue for investors and traders to absorb in May will be the fundamental lack of clarity regarding two issues: the state of the U.S. economy and global interest rates. On the former, the now-famous Atlanta Fed GDPNow forecasting model is now the single most important barometer of economic growth expectations.  It has a Q2 estimate of 0.9%.  The next update will be Friday, incorporating the ISM manufacturing data out at 10:00am. On the issue of global interest rates, the German 10-year will be the instrument to watch. It began the year at 0.54%, got as low as 0.08%, and closed today at 0.36%. Yes, those all sound basically like zero to me as well, but on a percentage change basis it is enough to cause some excitement.  And higher U.S. Treasury yields, which is generally bad news for domestic equities.

The bottom line is that risk asset volatility is likely to trend higher from here. There simply are not enough solid narratives for investors to confidently value anything on the risk continuum from sovereign debt to biotech stocks. Is the U.S. tipping into recession, pulled over by a stronger dollar?  Are bond investors finally waking up to the notion that buying long term debt with negative yields is a bad idea?  Will bond buying by the Bank of Japan and the European Central Bank improve those economies, or simply increase the price of financial assets?  Are U.S. stocks still priced to perfection in an increasingly imperfect world?

Let’s just hope investors hold to their belief that it’s the house’s money at work here, and that they don’t walk randomly out of the market.