why all the selling?

Little changed fundamentally over the past two weeks with regard to interest rate expectations, earnings expectations and the potential length of a trade war with China. So why did the last week of November witness some of the strongest historical returns in quite some time and this past Tuesday saw some of the harshest selling in several years?

To understand what is going on you need to focus on psychology. There has been ongoing research trying to explain market sell-offs. Several researchers had an interesting idea to try to explain why intense market selling occurs: instead of looking for an economic explanation - a repricing of earnings due to a policy change or changing expectations of future interest rates - why not instead go and ask institutional investors why they sold during the market downturn.

The findings were fascinating but not surprising - what they discovered is the main reason large institutional portfolio managers sold during market corrections is that stock prices were falling. Investors were reacting to price movements instead of to changing fundamentals - the selling effectively snowballed because large institutional investors sold stocks because other large institutional investors were selling stocks.

The problem for today's market is that this lemming-like behavior of selling stocks because others investors are selling stocks is becoming a self-fulfilling prophecy due to algorithmic trading. If we look at a sample of three of the largest multi-strategy hedge-funds they might collectively manage only $100 billion dollars in assets but through leverage they can deploy half a trillion dollars. Additionally, most of these firms are focused on using leverage to generate returns on a very short-term time horizon.

Essentially, multiple firms, by analyzing past price movements independently through various means, have come to the same conclusion that the psychologists examining market corrections came to - that during large negative market movements selling accelerates.

The key lesson for investors is relatively straightforward - as much as possible try to ignore price movements when making buy and sell decisions and instead focus on changes in fundamentals. The silver lining in the increased volatility is that the higher volatility should result in a higher rate of return for long-term equity investors as they need to be compensated for the volatility which does not look like it can be diversified away.

-- Mitch on the Markets, 12/8/18