Is the stock market stupid?

 

Simon Edelsten

This article was originally published in the Financial Times

I have spent the past few days in Sweden, playing bridge in the Chairman’s Cup. On Saturday, 159 teams of four started playing 12 rounds of eight boards each. By Sunday lunchtime my team was sixth. I was thinking we were pretty hot bridge players. Three hours later we were 92nd and shell-shocked.

The experienced members of my team are used to the ups and downs of bridge. They knew to be wary of overconfidence stemming from our brief surge up the table — and not to be too shaken by sinking to 92nd. They didn’t read too much into the numbers.

Having spent more time managing equity funds, I note parallels.

If you are sitting on nice gains this year, you might be feeling as confident as I was — all too briefly — on Sunday lunchtime. The FTSE has reached new highs. So has the S&P 500 (although not in pound terms, because of the fall in the dollar). In Europe the Euro Stoxx 50 recently broke a record that had stood for 24 years, which tells you something about the state of markets there over the past couple of decades.

But does any of this tell us what lies ahead? Many people try to read the markets, looking for signals in the numbers, like Roman priests poring over the entrails of sacrificed sheep to tell the future — a practice known as haruspicy. There was a less gruesome form of divination that appeals to my other interest — observing the flight and behaviour of birds. That was ornithomancy, in case you are interested.

All of it was nonsense, of course. But is it just as foolish to try to divine the future from the behaviour of financial markets? Let’s call it “finomancy”.

There are a few basic principles that are widely inferred by “finomancers”. When bond yields are low — specifically, the gap between traditional and index-linked bonds — it suggests there will be little inflation ahead.

When short-term bond yields are higher than medium-term yields, it allegedly warns us of impending recession. And when equity market levels rise, growth is expected. Let’s all party!

There may be more truth and meaning in these indicators than in the colour of sheep entrails, but be careful. It is not that these things will happen but that the market thinks they will. The market is simply a reflection of the attitudes and moods of millions of participants. Some call it “the wisdom of the market”. But the market can be stupid sometimes. The problem — as I can tell you from my bridge experience this week — is that the moods of its participants can swing violently.

Warren Buffett described the equity market through a character he named “Mr Market”. Mr Market is manic — sometimes euphoric, sometimes depressed.

Investors have the best chance of making money when Mr Market is at either extremity. This is when it is best to make big long-term decisions. In each case money is made by going against the herd. Take “what the market says” and, if your view is different, trade against it.

If you think inflation will be higher, buy index-linked gilts rather than conventional gilts. If you think that there are financial risks not priced in, avoid financials. If you think the AI boom is overhyped, avoid the largest of those stocks. That still leaves a long list of reasonably priced shares that you can hold — the unfashionable sectors, from healthcare to telecoms.

Most of the time, of course, markets chug along calmly — as now. There is something odd to me about this current serenity, though. It is not that equity markets have risen, but that they have done so with very low volatility.

The “finomancers” tell us that volatility is what the market thinks about risk. Low volatility suggests the economic and political situation is stable. Look at a volatility chart for the year and it is all calm apart from one big spike after Trump’s so-called “liberation day”, when US tariffs were announced.

Many fund managers who thought the tariffs flew in the face of economic sense and were bad for growth jettisoned shares, only to see markets subsequently recover.

So is the market correct in thinking that current conditions are now much more stable? Can you invest with confidence? Or is this unwarranted calm itself a form of extreme thinking?

The “mere 15 per cent” tariff agreed between the EU and the US shows the EU as a weak negotiator. The tariffs on Taiwan, Switzerland and Canada seem to hurt America’s friends more than the China deal limits its rivals. It’s not clear how much damage all this will do to growth or to inflation in each region.

When markets are this subdued — neither hyper nor depressed — it can mean that investors are sitting on the fence, afraid to make a big call.

In my experience, that is normally one of those times to make a big call. The market is not telling us that risks are low or that there is little to worry about. It is leaving us to express our own views through our investment approach. Me? I am becoming increasingly nervous. The market can be stupid sometimes. That doesn’t mean you have to be.

 

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