The Miraculously Malleable Market

We all like to search for the underlying causes behind a market move. Some days, the catalysts are obvious. Other days, not so much. Over the years, I’ve fielded many calls from reporters who were struggling to find a narrative to explain a day’s market activity, only to struggle to offer one of my own.   

I have spent the bulk of my career in search of tradeable cause-and-effect situations. I was a systematic trader before the term morphed into the more sophisticated-sounding algorithmic trader. The Holy Grail is a foolproof system where a stable set of inputs results in a predictable set of outcomes. In theory, this seems easily achievable. In reality, it’s incredibly difficult.If it was easy, hedge funds and other trading firms wouldn’t need to employ teams of quantitative experts to find and refine those relationships. 

A big hurdle is that markets need to continuously deal with exogenous events and that investors’ reactions to those events are filtered through human psychology. Emotional reactions are incredibly difficult to model, however. So are expectations, or more specifically, knowing which expectations are already discounted by investors and which are not. A skilled equity analyst may come up with a detailed rationale for why a company should be expected to earn 60 cents this quarter. Yet if the company actually reports 60 cents, the market reaction is still an open question. Were investors really hoping for a penny or two more? Does the company’s management offer a positive or gloomy outlook for the coming quarters? Is there a big upsurge or downswing in the broader market that renders the results somewhat irrelevant that day? And how do we model investor reactions to all those questions?

Despite those problems, markets still seek narratives anyway. A common one for stock investors is to follow 10-year Treasury yields. But stock investors can read the messages from the bond market in various ways. Let’s consider the relationship between the 10-year and the NASDAQ 100 Index (NDX), pictured below. We have heard the rationale that investors should be favoring the mega-cap tech stocks that dominate NDX when rates fall because lower rates mean that the present value of those companies’ future cash flows increase when they are discounted at a lower long-term rate. There is truth to that logic, though I have frequently questioned whether investors in those stocks are actually concerned with valuation. 

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