Behavioral economics is a well researched field of study and one we find important as it pertains to acting as a fiduciary and a steward of capital. In this newsletter, we reflect on recent research into this topic and attempt to blend it with recent market actions hitting the globe as we speak.
We came upon a research paper entitled “How Basic Are Behavior Biases? Evidence from Capuchin Monkey Trading Behavior” authored by Chen, Lakshminarayanan, and Santos of Yale University. With such a title, one can understand how it went to the top of our reading pile. The researchers wanted to determine if the economic attributes shown in humans are also shown by other primates. The evidence suggests that Capuchin monkeys exhibit many of the economic traits of humans. The findings were very interesting, particularly as it pertains to aversion to losses when the presented with varying ‘gambling’ scenarios. When confronted with different potential outcomes, the monkeys favored outcomes with superior risk adjusted returns – a rational choice. As we witness the recent human behavior in the markets, we wish investors would consistently react the same way. We highlight three specific events hitting the world at this moment that bring about this concern.
Greece Debt Negotiations
Greece has over $300 Billion in debt (almost 2x its economic activity). It cannot independently support that burden and continue to offer the services its population has grown accustom to. Greece has been gambling with its future by choosing an unsustainable economic scenario. The current situation is finally hitting its breaking point. Something needs to change and the negotiations between those that hold the debt (mostly other European governments) and the newly-elected Greek government have made little progress. Tempers are flaring with the European Council president stating “There is no more time for gambling. The day is coming, I’m afraid, that someone says that the game is over.” This has produced fear in the global markets as concerns over the knock-on effects of a Greek default and/or exit from the European Union are unknown.
The world has been discussing the eventuality of Greece defaulting or leaving the EU for some time. We have seen the European Central Bank take precautions to mitigate the impact with the launch of the Expanded Asset Purchase Program (initiated coincidentally at the same time the new Greek government came into office). From our perspective, whatever the outcome, the risk of it impacting the world markets are low given that the majority of the debt is held by Germany, France, and Italy ( which should be capable of handling the default). The region’s banks have been positioning for an eventual change, making us less concerned of a contagion.
European Sovereign Debt
With the introduction of quantitative easing in Europe, the financial markets saw strength in German sovereign debt. Investors purchased 10-year bonds to such a large extent that the rate approached zero in this past April. That gamble, which assumed that short term investors would be able to profit from the central bank’s bond purchases, did not pay off. Over the course of the last two months, we have seen the unwinding of that bet with the interest rate of 10-year German Bund going from 0.08% to 0.90% (a significant percentage jump). Although large in magnitude, this increase only resulted in rates that were the same as the beginning of the year.
At this time, we see Bunds in the ballpark of normal and expect to see the southern countries experience modest rate lift as fears of future dislocations take hold. However, the combination of large economic slack in the periphery, moderate inflation readings in most of the region, and continued support by the central banks increase the likelihood that rates stay low. We do expect the increased volatility experienced over the past two months to become the new normal, at least for now. We look to take advantage of the volatility to build up our European equity exposure in areas we see better economic activity leading to better asset pricing.
Bull in a China Shop
The World Federation of Exchanges came out recently with a list of the largest equity market exchanges in the world. China has come up the ranks and now holds two of the top 5 positions. The overall size of the Chinese stock market is over $10 Trillion, making it the second largest in the world. Although this may not be surprising given China’s size, the speed of attaining that distinction is surprising. The Shanghai index is up over 60% year-to-date and the Shenzhen exchange has seen growth of 120% this year.
- New York Stock Exchange – $19.7 trillion
- NASDAQ OMX – $7.4 trillion
- Shanghai Stock Exchange – $5.9 trillion
- Japan Stock Exchange – Tokyo – $5 trillion
- Shenzhen Stock Exchange – $4.4 trillion
- Hong Kong Stock Exchange – $3.96 trillion
- Euronext – $3.5 trillion
These significant increases appear to be driven by individual investors exiting out of real estate investments and moving funds into the equity market. According to BNP Paribas, new brokerage account openings were running 10 times higher this year as compared to last year. In addition, a State Street Bank survey highlighted that a Chinese stock market participant is almost twice as likely to make monthly trades versus a US participant. Accordingly, we may have the making of a huge gamble in the future performance of the Chinese equity markets. There is no doubt in our minds that China will continue to play an increasing role in the world, but we do find it difficult to see outsized returns continue.
Normal Doesn’t Always Feel Good
We stated at the beginning of the year, and continue to believe, that 2015 will be a ‘normal’ year. The volatility seen across the globe and the gambles mentioned above do not change that opinion. These events, and many others not discussed, do not feel good but they have always been part of a normal market environment. At this time, our readings of risk in the market are not highlighting any need to be overly cautious. Now, that can change quickly and we will respond if they do, but at this time we see volatility as an opportunity rather than a concern.