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I Hate This Market, I Love This Market

Posted by hkarner - 26. April 2016

Date: 26-04-2016
Source: The Wall Street Journal

The plunge and then surge of commodity prices this year shows investors have spent more time watching each other than watching the fundamentals

In markets, as in life, a sudden fright can quickly be replaced by embarrassed laughter. The fear evident earlier this year has already been superceded by nervous giggling in Western equity markets, while in some areas of commodities, where the shock was deepest, it seems to have turned into full-on hysterics.

Anyone who bought back into commodities at their bottom in late January has been laughing all the way to the bank. By the end of last week, global mining shares had rebounded 75%, the strongest over a similar period since at least 1994, when data for the FTSE World Mining index starts. If that sounds like a lot, consider the frenzied trading in the previously obscure futures contract for steel reinforcing bars, or rebar, in Shanghai last week, where turnover was higher than on the entire stock market.

These wild swings in investor emotion took place while the world economy showed no more than mild fluctuations, and corporate profits took a hammering.

Understanding how this could be is essential for those trying to work out whether the rally has run its course. It also illustrates once again one of the great truths of investing: Those in the market spend a lot more time watching each other than they do watching the fundamentals.

The simple explanation for what happened is that investors became far too pessimistic in January and early February. When the economic data remained merely mediocre, rather than heading for the mess many were anticipating, they realized their mistake and the race to get back in prompted extraordinary—in the case of mining shares, record—bounces.

Commodities provide the most extreme example of how scared investors were. Hedge funds and others who speculate in the futures market were about as negative toward commodities as at any time since 2003, according to David McBain, head of technical strategy at Absolute Strategy Research.

Sentiment toward equities wasn’t quite so bad—but still terrible. Investors thought the financial world was heading for an abyss. When they decided it wasn’t, or at least not yet, their relief was as intense as their previous panic.

So can it continue? Sentiment measures mostly say yes, at least for a while.

In commodities, speculative bets on gains now outweigh bets on further falls, but not by much. Positioning could easily become far more positive yet on U.S. futures exchanges before it begins to look stretched, although perhaps not in China, where full-on speculative fever seems to have taken hold. In Shanghai, both the rebar and hot-rolled coil steel futures have more than doubled in price this month, while several other commodity contracts have also leapt, prompting exchanges to try to cool the market.

In equities, sentiment has moved from deeply negative to somewhat positive. Again, there is scope for investors to become far more bullish before there is any need to worry about overexuberance.

Of course, sentiment is only part of the story. In the longer run, the worries behind the selloff at the start of the year haven’t gone away so much as been pushed further into the future. The two most obvious were that China’s struggling economy would prompt a devaluation, hurting developed-country manufacturing, and that the U.S. might be on the verge of a recession.

Solid data from both China and the U.S. showed neither was imminent. But China’s improved performance was underpinned by yet more lending, hardly a panacea for an economy where the main concern is that corporate debt is unsupportable. And the U.S. is still showing only weak growth, in spite of decent job creation.

This year’s swings show once again the difficulty of focusing purely on fundamentals, when so many traders are focused instead on each other.  The great economist John Maynard Keynes put it best in 1936 when he likened the market to a beauty parade, in which judges have to pick not the prettiest girl, but the girl most popular with all those voting. The way to make money in the short run is to anticipate whether the crowd will be pushing the market up or down, not what will happen to profits or the economy.

In the long run the fundamentals matter, but in the long run, as Keynes said in a different context, we’re all dead. For fund managers, what counts as the long run is an ever-shorter time period, and even for those with loyal clients is an absolute maximum of three years. Underperformance means customers quickly take their money elsewhere, and sales dry up. No wonder they are paying so much attention to the mood of their competitors, even as profits fall and economic growth goes nowhere.

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