In times of peak uncertainty, market participants tend to look at the bigger picture for answers. I’m not talking about the big philosophical “whys” of life (e.g., Why do I exist?), but the more market oriented questions: What is causing this market behavior? Why is it happening? Can it continue?
Certainly, this discussion is taking place now that the markets are reaching nine month lows. Pundits lament that corporate earnings are projected to be very strong when second quarter numbers are rolled out. The bears point out that state and local governments will have trouble balancing budgets with current revenue shortfalls and bailout money fading. This will lead to payroll cuts that directly affect consumption patterns and will have trickle down effects on the economy.
As with most macroeconomic analysis, it’s almost impossible to tell which point of view will win in the intermediate term. We do know, however, that this market downturn has added a significant element of fear back into the market. Multiple media outlets report that Google searches for phrases like “double dip recession” have increased in the last ten days. And, as reported in Barron’s, many professional money managers are moving more toward cash.
Some of the most intriguing work that I’ve been looking at points to a structural change taking place in market activity. Let me explain what I mean by structural change and then we’ll look at what might be brewing.
The Nature of Structural Changes
Some would argue that we have just entered another bear market phase in equities. That is a change in market category or type. When I talk about structural changes, I’m referring to fundamental changes in the way markets operate over time. Any number of causes can produce this level of change, but I’ll mention three of them today: technology, regulation, and financial innovation.
New technology, like the telephone in Jesse Livermore’s day or in the Internet in ours, has certainly caused changes in how the markets behave (among other effects, both of these technologies shortened the news cycle).
Regulatory changes definitely have affected the way markets behave. When margin requirements were raised from 10% to 50% after the 1929 crash, fewer dollars were chasing the same amount of shares. The data reporting and execution changes made in 1997 that made intraday trading possible for retail traders ushered in a new order of magnitude of volume into the market. Decimalization further reduced transaction costs and almost completely killed one type of trading (retail market making became virtually unprofitable).
Financial instrument innovations have also led to structural market changes. Mutual Funds allowed retail investors to participate in equities markets on a scale never before seen. Derivatives allowed institutions to hedge risk and/or take on huge leverage in ways that were not possible previously.
A New Structure: The Same Investor Psychology but Bigger and Faster
All of these changes led to different trading and investing dynamics. At their core, however, market movements remain driven as always by the cumulative effects of the market participants’ fear and greed. We can display the classic investor psychology market cycle of bottom, rise, peak, fall on a chart as a sine wave.
Even though the forces that drive the markets remain the same, it fascinates me that their expression is evolving. If you think about the cycle of a sine curve, it moves up and down a certain amount and it repeats within a certain time frame. Structural changes in the markets are altering the characteristics of that cycle. It seems that the amplitude (the level of highs and lows) is increasing while the frequency (time between successive highs or lows) is getting shorter.
I saw the chart below in a blog recently. This intriguing graphical display depicts the expanding amplitude of the moves of the Dow over the past 12+ years. 481-dr-chart1.jpg 18,44К 0 Количество загрузок:
We’ve crossed below the “12 year breakeven” line since this graphic was made in May 2010 with the Dow closing at 9774 on Wednesday. But the reality of the chart is stunning: bigger and faster climbs followed by bigger and faster drops. And for the past 12 years or so, this led long term investors on a road to nowhere.
This visual is perhaps the best that I’ve seen that truly shows how buy and hold is dead. Imagine the work involved holding onto investments for 12 years that included an Internet boom and a real estate boom and having no gains to show for the effort in the end.
In the coming weeks, we’ll look at some additional evidence that structural changes are underway in the markets.