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Wednesday, 15 April 2009

Rational investing in an irrational world

Correctly anticipating the impact of a news report, rather than the news itself, is one of the most useful skills of the accomplished investor


FROM fear to euphoria in one month? In the last couple of weeks, we had the steepest US stock market rally in 70 years.

As we contemplate the investment outlook post-sub-prime global stockmarket crash, it pays to look back and remember that financial markets have an incredible capacity for reacting to news and economic developments in a way that confounds market professionals and retail investors alike - the only difference being the latter will admit to being confused, while the former will quickly come up with a few dusty rationalisations.

Our sell-side friends at many Wall Street banks now preach that it is time to buy cyclical stocks as the worst is over. The more independent-minded, however, such as George Soros or Marc Farber, warned that the market got ahead of itself and that a correction of at least 10 per cent is highly likely.

Economist John Maynard Keynes put it best when he remarked: 'Nothing is more suicidal than a rational investment policy in an irrational world.'

In the long-run, true value is always revealed but in the short-term, the market and individual stocks and bonds get pushed and pulled by a variety of forces - portfolio re-balancing, rumours, news, investment fads, seasonal tendencies - that have nothing to do with fundamentals. Lord Keynes also said: 'In the long-run, we are all dead and, in the short-run, you get a margin call.'

In the long-run, true value is always revealed but in the short-term, the market and individual stocks and bonds get pushed and pulled by a variety of forces that have nothing to do with fundamentals.

Monitoring economic reports is a very important but overlooked area of trading and investing. Nowhere are the advantages and drawbacks of a Blackberry world of instantaneous electronic communications more evident than in the financial markets. A long-term price trend might seem obvious or inevitable in retrospect, but in the short-term, markets are pulled and pushed by a never-ending stream of news-like economic reports, statistics and earnings.

As the speed and range of market news has increased, so has the challenge of interpreting it - or more accurately, managing the market's reaction to it. When deciphering economic indicators and market news, it is important to understand that in an Alice-in-Wonderland world of global financial markets, bad news can be good news and good news can be bad news. The economic context in which a news report is released is the key to resolving these paradoxes.

Correctly anticipating the impact of such news, rather than the news itself, is one of the most useful skills of the accomplished investor. In financial markets, the impact of the data is not always what it should be (or what we think it should be). What initially appears to be a 'bad number' is sometimes followed by a rally of steady buying.

Similarly, a report that seemingly underscores economic strength may be met by frantic selling. Investors who have learnt to survive and prosper in the markets use this flow of information to form intelligent expectations about the market's chances/probabilities of trading up, down or sideways. The macroeconomic flow also plays a key role in determining individual sector trends: Is it time to rotate out of telecoms stocks into banking stocks ?

Having said that, when it comes to macroeconomic news reports that rock the market, the most important thing is to understand that it is not the number itself that counts but rather what expectation has been built into the number and how the market reacts to it. When contemplating how an economic report may affect the market, there are three crucial points to keep in mind. First, all indicators are not created equal. Second, the news is not always what it seems; and third, context is king.

To better understand the often confusing reactions to economic data, remember three points:

- Sometimes bad news can be very good news.

- First impressions do not always last.

- Only deviations from expectations truly move the market.

Investment management is an art, more than a science. The broader point is that assessing the market's reaction is much more a complicated game of chess than simple checkers. The picture is always changing. It comes into play when expectations about the future have a bearing on present behaviour - which is the case in financial markets.

Some mechanism must be triggered for the participant's bias to affect not only market prices but the so-called fundamentals which are supposed to determine market prices. The fundamentals that you read about in newspaper or research reports are usually useless as the market has already discounted the price. However, if you caught them on early before others, then you might have valuable 'surprise-a-mentals'.

When it comes to investing, Albert Einstein's immortal 'imagination is 10 times more powerful than knowledge' holds very true. A good investor cannot be rigid. If you can find someone who is really open to seeing anything, then you have found the raw ingredients of a good investor and/or investment adviser.

When news comes out, the market should act in a way that reflects the right psychological 'tone'. Technical analysis gives an investor valuable information, fundamentals give an investor valuable news. Fundamental analysis creates what might be called a 'reality gap' between what should be and what is. So am I bullish or bearish right now? I do not know. My goal is not to be either, it is to pick up good risk/reward situations. I remain open-minded and flexible.

The past is fixed and easy to analyse. The future is fluid and uncertain. You have to base your decisions on probabilities in an atmosphere of uncertainty.

The writer is a chartered wealth manager and can be reached at:
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