What drives markets? In the short term, financial commentators we follow often cite a broad array of different headline news stories. According to Fisher Investments UK’s research, though, markets’ longer-term, more material moves hinge on surprise – the gap between reality and expectations. What does that mean in practise and how can investors use this framework to their advantage?
Based on our analysis, stocks concentrate on probable economic conditions over the next 3 to 30 months or so, meaning backward-looking data have little effect on markets beyond a possible short-term sentiment impact. Sometimes newly released data can jar expectations and grab headlines, causing short-term market fluctuations, but we don’t think they alter stocks’ longer-term direction much. In our view, this is because stock prices reflect what just happened and what is immediately ahead – those conditions’ impact on corporate results are likely well-known already. At the same time, we don’t think far-out forecasts affect stocks much, either, since markets can’t price in very long-term estimates given all the variables to consider. We think markets’ inability to assign probabilities to distant events’ outcomes means discussion about them mostly just fades into the background noise.
Moreover, because owning shares entitles investors to companies’ future profits, we have found stocks focus on the factors likely to impact corporate earnings. In Fisher Investments UK’s experience, markets quickly price in all widely available information about corporations’ prospects. In this way, we think stocks relentlessly scan the foreseeable future, adjusting their earnings outlooks accordingly.
Fisher Investments UK’s research shows stocks move primarily when probabilities suggest reality will differ from baseline expectations. Consider early-2020 COVID lockdowns’ extreme example. The MSCI World Index peaked on 20/2/2020, days before the developed world’s first regional lockdowns in Italy.[i] Until then, we think markets were expecting global economic and earnings growth despite news of COVID in China and the city of Wuhan’s January lockdown – not unlike earlier regional Asian epidemics, including multiple Avian Flu outbreaks and SARS’ 2002 – 2004 spread. But when COVID hit Europe – and widespread containment policies’ likely negative economic impact became apparent – markets began fathoming the probable hit to corporate earnings. Stocks promptly fell -26.1% to 16/3/2020, pricing global recession – and then some, in our view – modern history’s quickest bear market (fundamentally driven decline exceeding -20%).[ii]
Then stocks rose.[iii] What happened? After markets priced in worst-case scenarios on the near edge of the 3 – 30 month window stocks look through, Fisher Investments UK think they then looked further ahead toward the far end, to a time when severe national lockdowns would be more exception than norm. Before statistical agencies even published negative economic readings tied to lockdowns – much less any reports signalled recovery – markets rallied, pricing in swift growth as economies reopened, in our view.[iv] The Centre for Economic Policy Research’s Euro Area Business Cycle Dating Committee didn’t hint at recession (extended, broad economic downturn) until May 2020 – two months after the fact.[v] The US’s recession was the shortest ever – though economists didn’t officially declare it over until more than a year later.[vi] We see this as an unusually clear illustration of surprise moving markets.
Now, lockdowns’ huge initial economic effect – and market surprise – is uncommon, but we think its lesson is widely applicable. How can investors use it? In everyday practice, we find tracking market sentiment to monitor the surprise gap versus likely reality influences stocks’ longer-term direction. Gradual positive surprise is more typical, based on our historical observations. We think that is why bull markets (periods of generally rising equity prices) predominate.[vii] If headlines, surveys and other investor confidence measures we follow are largely pessimistic or sceptical about the economic outlook, that can lower the bar for reality to surpass expectations. If outcomes prove better than expected, we think the resulting relief – whether conscious or unconscious – helps power stocks upward.
When reality is far worse than anticipated, however, a bear market can strike. Our research shows bear markets form in one of two ways: what Fisher Investments UK refers to as the wall or the wallop. In bull markets, we have found stocks proverbially climb a wall of worry, rising as relief pushes them gradually and irregularly higher. Often, as bull markets progress, we have observed worries fade and sentiment grows more and more optimistic. In our view, if sentiment becomes broadly euphoric, expectations may become very difficult to exceed, possibly setting up the conditions for a bear market as investors overlook negatives and expect unrealistic positives ahead. We think this is when stocks are atop the wall of worry, as concerns evaporate. We define a wallop as when an event capable of wiping out global growth unexpectedly hits – e.g., the first pandemic lockdowns worldwide. Crucially, though, we think such a multi-trillion pounds economic negative must be surprising – something most don’t see coming. If everyone did, we think markets would have probably priced it already – and it wouldn’t likely cause a fundamental wallop, in our view.
Opportunities – and risks – open up to us depending on how far expectations veer from reality. We think minding the gap between them can shed light on the factors likely to move markets materially versus temporary swings – a key advantage over the crowd, in Fisher Investments UK’s view.
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Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom.
Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.
[i] Source: FactSet, as of 9/5/2022. Statement based on MSCI World Index returns with net dividends, 20/2/2020.
[ii] Ibid. Statement based on MSCI World Index returns with net dividends, 20/2/2020 – 16/3/2020.
[v] “The Latest Findings From the CEPR - EABCN Euro Area Business Cycle Dating Committee (EABCDC),” Staff, Centre for Economic Policy Research, 7/5/2020.
[vi] “It’s Official: The Covid Recession Lasted Just Two Months, the Shortest in U.S. History,” Jeff Cox, CNBC, 19/7/2021.
[vii] Source: Global Financial Data, Inc. and FactSet, as of 25/3/2020. Statement based on S&P 500 price index level in US dollars, 6/9/1929 – 24/3/2020. Currency fluctuations between the US dollar and pounds may result in higher or lower investment returns.