Investing, Causality and Human nature.
The following are a few philosophical musings on recent market action and how it relates to human nature. As such, it is perhaps not exactly ‘actionable’ information or analysis as far as investment decision making is concerned. (You have been warned…)
Japanese equity markets have gone through a rather volatile couple of weeks. The Nikkei 225 topped out on the 22nd of May at 15,706 and subsequently fell 18% to 12,877 intra-day on the 7th of June, before bouncing roughly 5%. These are quite large moves, but perhaps not in the context of what has happened leading up the to this correction, i.e. an almost doubling of the market, depending on which index you look at.
On the 23rd of May we illustrated this point in the following manner:
“Imagine a large room (Japanese equities) with a single door (the Tokyo Stock Exchange), through which a small number of people (investors) trickles in every day in an orderly fashion. After 8 months all of the investors in the room suddenly and simultaneously perceive a reason to exit the room, and when that happens the single door through which they came in simply is not big enough to accommodate all of them in an orderly fashion. In other words – in terms of market liquidity, the Japanese equity market simply is not deep enough to handle outflows on that scale.”
The full piece can be found here: https://nipponmarketblog.wordpress.com/2013/05/23/nikkei225-7-32/
The above representation, albeit a quite accurate and evocative description of events, was also somewhat superficial. So what precisely happened during the past few weeks? What triggered this correction? Well, the conventional wisdom subsequently seems to be that because the Federal Reserve was hinting (in a rather clumsy way) at ‘tapering’ of its QE program, the global equity markets got spooked, along with currency markets which had an additional negative impact on the Japanese equity market.
Notice how this would appear to be an almost complete explanation of events, but this then also raises the question; If it was all this simple, why did it not happen before, and why didn’t everyone see it coming? The answer lies in the question itself; It is not that simple, and nobody really knows precisely why it happened, or more specifically why it happened now.
The global financial system is almost certainly the most complex system ever devised by man. Trying to map it all out and describe how individual elements relate to each other would require a multi-dimensional correlation matrix of mind-boggling scale, and it is probably fair to say that most correlation coefficients within it are quite unstable over time, and some are simply ‘unknowable’. The truth is that no one person (or organisation) is able to fully understand the entirety of this dynamic system.
However, this does not stop us from collectively thinking that we have positively identified the explanation for, and the causality behind the recent events. And as with many things in human affairs, whereas individually we tend to strive for the most accurate explanation for observed events, collective we seem to invariably drift towards the lowest common denominator. This is as true for causality analysis like the one presented above, as it is true for things like analysis of equity valuations. Despite the existence of very sophisticated accounting based valuation models incorporating ‘time value of money’ (using Discounted Cash Flow models), over the long term and in aggregate the markets seem to operate primarily based on simple PE multiples. Why? Because it is so simple that most of us can understand it.
In the context of the causality behind the recent equity market correction, the ‘Fed Tapering’ argument looks deceptively like the trigger, and we would not argue that it didn’t play a role, especially in light of the unprecedented levels of central bank created credit currently sloshing around in the global financial system, and the obvious effects that this has on asset prices and asset pricing. But the correction in the equity markets would almost certainly have happened even without the slightly bungled communications effort by the Federal Reserve. The trigger could have been virtually anything, and it would have been just that – a trigger, as opposed to the underlying cause. But once the move was initiated, the momentum quickly picked up, and in the end resulted in a loss of 18%, or more than half a trillion USD across the Tokyo Stock Exchange.
The real cause behind sell-offs like the one Japan has just witnessed lies much deeper, and simply rests in the innate complexity of the entire financial system, comprised as it is of millions of interconnected agents, entities, financial and economic institutions and effects, all constantly affecting each other and constantly changing independently as well as interdependently, in an enormous and utterly opaque feed-back loop. Once it starts moving it often becomes self-reinforcing, whether initially set off by downgrades to global growth, another round of sub-standard communication from the BoJ or random sell orders that then trigger VaR-induced risk reduction trades, it quickly takes on a life of its own and starts falling…. because its falling.
Taking a slightly philosophical slant on the topic at hand, it appears to NipponMarketBlog that a large part of this issue relates to our evolution as primates here on this planet, and our perception of causality within this world that we have evolved as a part of.
Everything that happens on planet Earth either has or at least seems to us to have a cause. ‘Cause’ being different from ‘reason’. If a tree falls over, the root system must be weak; or the ground must have shifted; or there must have been a storm; or an elephant must have pushed it over.
Whenever we humans are faced with any observation of anything, our brains immediately and subconsciously begin to search for causality, because in the physical world that we have inhabited for around 6 million years, causality is enmeshed in everything around us, and so this has been an excellent tool for understanding and attempting to control our environment through the ages.
Precisely because we have evolved in this way, we naturally tend to apply the same dynamics to the way we look at things like the equity market, even if this is an entirely ‘non-physical’ world. If the market is going up, ‘there must be an explanation’ (thinks the primate), and guess what – he finds one. We see it every day, when the market’s talking heads take a look at what has transpired and then begin to assign reasons for what has happened. We are simply conditioned to operate like that.
However weak or unlikely the perceived causality might be, we assume the existence of this causality where little or even none exists, because we simply have to. Our primate brains are wired that way. We cannot NOT have causality.
And this is where the danger lies, because what is the outcome of all this, as far as investing is concerned? The outcome is of course imperfect information (lowest common denominator effect), ‘recency bias’ (putting more weight on recent events), an irrational and subconscious insistence on seeing causality where actually there is none, and resultant inadequate information for drawing conclusions, shaky foundations for decision making, and ultimately bad investment decisions and arguably even worse government and central bank policy decisions.
Imagine being just one individual, subject to these forces that are deeply ingrained in the human psyche, and having to grapple with trying to steer these immensely complex financial system processes along a pre-determined path, and from which any deviation will be interpreted as a failure. Disconcertingly, this is the task facing BoJ governor Kuroda.
In writing this, NipponMarketBlog is reminded of a quote by Hayman Capital’s Kyle Bass when asked what he would do if he were to be hired to take over the position as governor of the BoJ.
Without even a moment’s hesitation, Mr Bass replied: “I would quit.”