Effective investment decision-making requires understanding the complex dynamics between changing economic conditions and investors’ market behaviour.
The strong influence of prevailing economic conditions on investor behaviour is widely underrated. Any significant change to economic conditions brings a marked change in investor behaviour, which in turn is reflected in asset prices. Changing economic conditions could make once-popular assets—usually trading at lofty valuations due to their popularity—unpopular, adversely impacting their prices.
The adverse impact on asset prices could happen despite no changes in the asset’s fundamentals. Hence, an investor must evaluate an investment idea within its economic context to determine its prospects. He should also stay alert to changing economic conditions and interpret how those changes could sway the prospects of his investments.
Economic conditions can broadly be classified into easy, normal, and challenging. Each condition instils different investor behaviour, determining the change in asset prices and their valuation. Investors are highly risk-tolerant during easy conditions, causing them to even indulge in leverage to prop up their returns.
However, investors’ risk tolerance diminishes as economic conditions shift from easy to normal or challenging. Reduced asset prices are the most obvious consequence of investors’ diminishing risk tolerance (or increasing risk aversion). However, more harmful consequences might occur once investors are forced to unwind many of the risky bets they have made during the easy times.
Low interest rates, abundant liquidity, casual lending standards, and relaxed regulations characterise easy economic conditions. These conditions breed similar kinds of investor behaviour: casual, fervent, imprudent, and sometimes, reckless. Easy economic conditions emanate from efforts by regulators and authorities to stimulate a sluggish economy, decimated by a crisis or a recession.
These efforts are effective most of the time. However, an adverse effect of easy conditions is the extremely low returns from traditional investment assets such as bank deposits, bonds, and treasuries. Consequently, investors are forced to embrace more risk to achieve their expected or desired return.
‘Investing in risky assets’ and the ‘use of leverage to prop up returns’ are two common avenues through which investors embrace more risk.
Suppose that 10 per cent is a desired return for a particular class of investors, but their preferred asset could now deliver only a 7 per cent return due to a decline in interest rates. However, by leveraging their investment using cheap borrowings with financing cost less than 7 per cent, these investors can prop up their return to their desired return of 10 per cent.
Investors have two choices during easy times when prospective asset returns are low: they could hold on to high standards and settle for lower returns or take on more risk to achieve their desired return. Most favour the latter unwise choice.
Although easy times don’t last forever, investors make decisions during these times assuming they will last forever. However, sooner or later, certain economic forces will emerge that set off the imminent return to normal economic conditions: high inflation is the most usual culprit, but not always.
A rise in interest rates is a major ramification of moving from easy to normal economic conditions. But as interest rates rise, investors’ leveraged investments will start to backfire; instead of boosting returns, leverage now depresses returns. Consequently, investors will scramble to unwind their leveraged bets that have become unprofitable, putting downward pressure on underlying asset prices that were already under stress due to rising interest rates.
It was the lax lending standards adopted by lenders during easy times that provided investors with the borrowed capital to leverage their investments. Imprudent and impetuous economic behaviour during easy times is not just confined to investors: lenders, regulators, and business executives are complicit in propagating, generalising, and legitimising the behaviour.
During easy times, lenders lower credit standards and provide loans they wouldn’t have sanctioned under more normal conditions. Businesses overinvest based on a highly optimistic economic outlook, as if the easy times will last very long. Complaisant regulators overlook high credit growth that far exceeds economic growth; the rapid rise in asset prices to levels more than justified by their fundamentals; and the increasing indebtedness of businesses and individuals; because economic activity remains buoyant, inflation remains tepid, and unemployment remains low.
High economic growth, rapid rise in stock prices, abundant liquidity, and easy availability of cheap credit make ‘easy times’ feel like the ‘best of times.’ However, they are also the ‘worst of times’ because imbalances and distortions trickle into the economic system due to the impetuous and imprudent economic behaviours of economic participants, increasing the system’s precariousness.
It is because of credit that we have economic and business cycles. Credit translates small fluctuations in economic activity into much bigger fluctuations in corporate earnings, asset prices, and, most importantly, in the sentiments and behaviours of economic participants that include investors, lenders, borrowers, businesses, and regulators. Credit’s growth, cost, duration, and the sectors to which it flows are the most reliable indicators to make sense of economic conditions and prospects.
The worst form of credit is that made to conduct speculative activities. Buying assets such as stocks, bonds, currencies, or real estate just to profit from their rapidly rising prices is speculation. Real estate loans are generally long-duration loans; even if they are availed to make speculative investments, their unravelling due to adverse shocks is usually gradual and happens over an extended period; the Chinese real estate market of the past four years is a case in point.
However, the unravelling of credit used to speculate in financial assets such as stocks and bonds has more immediate, deleterious effects on the financial system. These loans – margin loans – have a very short duration (usually less than two weeks). A rise in pessimistic sentiments might prevent lenders from rolling over margin loans; a spike in market volatility might force lenders to rescind margin loans. Investors who had availed these loans to speculate on financial assets will then be forced to sell those assets, causing a precipitous fall in their prices.
In terms of their impact, what separates a precipitous fall from a gradual fall in asset prices is a sudden shattering of investor and business confidence. Businesses will now have doubts about their investment plans made under a highly optimistic demand outlook. Lenders will turn risk averse and toughen their credit standards, narrowing the credit window. Investors start to unwind many of their investment bets (including speculative ones) due to doubts regarding the validity of their earlier optimistic return expectations.
Because of credit’s involvement, the fall in prices won’t be restricted to just correcting the excesses; instead, asset prices, investor sentiments, and business confidence fall much more than warranted to depressed levels.
There exists a normal or natural level for economic activity, the level at which the economy operates most optimally, where the unemployment rate is at the lowest, and the economy grows at the maximum, without fuelling inflation. Inflation rises if economic activity goes above the natural level; unemployment rises if economic activity goes below the natural level.
But due to credit’s involvement and human psychology, the economy rarely operates at its natural level. Instead, the economy oscillates around its natural level, either above its natural level (excesses) or below the level (depressed).
The interest rate is the lever that brings the economy back to its natural level whenever it moves too far from it. If the economy has moved too far into the excess territory, interest rate rises to bring it back to the natural level. Likewise, if the economy has moved too far into the depressed territory, interest rate declines to bring it up to the natural level.
However, economic activity and asset prices always overshot their intended destination (the natural level) due to credit’s involvement and human psychology. Instead of retreating to the natural level from the excess territory consequent to higher interest rates, they overshoot to the depressed territory. Likewise, rather than rising to the natural level from the depressed territory consequent to lower interest rates, they overshoot to the excess territory.
The best time to buy stocks is when prices and sentiments are depressed; the best time to sell stocks is when prices and sentiments are elevated; the hard part is determining when they are elevated or depressed. Moreover, there is a question of timing: elevated prices can get further elevated, and depressed prices can get further depressed.
Only in hindsight do these factors become clear. Only after prices have fallen much… do we realise that… prices were elevated a few weeks back; likewise, only after prices have risen a lot… do we realise that… prices were depressed a few weeks back. However, insights from hindsight aren’t very helpful in improving our investment performance.
It is impossible to sell at the exact top or buy at the exact bottom, but an alert investor could determine, with reasonably good probability, when the prevailing trend is nearing its end. He could then use those insights to reposition his portfolio to navigate the soon-to-emerge trend.
Following the course of interest rates is the most reliable method to understand where we are in the market or economic cycle and, at the same time, guestimate trend changes. There are short-term interest rates (maturity less than 2 years) and long-term interest rates (maturity 5 years or more). If the difference between these two rates narrows, it signifies something; if they widen, that signifies something else. Rising or declining rates have different meanings depending on whether they happen during buoyant economic conditions or depressed economic conditions. In short, evaluating the significance of interest rate changes should be done in the context of the prevailing economic conditions.
There are no formulas to make sense of these… other than independent critical thinking.
Even if you can successfully foretell a trend reversal by interpreting interest rate changes, adjusting your behaviour as per the newly gained market perspective requires unusual strength and courage. The newly gained market perspective would be contrarian; they are more likely to look wrong for some time because market prices and the general investor behaviour follow the prevailing market perspective.
Soon, the changed underlying economic conditions would get reflected in market prices, causing investors to gradually shift their market perspective towards one that is more entrenched in the new economic reality. However, there always exists a time gap for changed economic conditions to cause a corresponding change in the general market perspective.
The best opportunities emerge during those time gaps. However, the actions you take to effectively utilise those opportunities might depart from herd behaviour. It calls for courage to embark on a path alone while watching all others follow the proven, long-trodden path. So long as the market perspective that guides your behaviour is routed in the right facts and right reasoning, staying on the contrarian path despite intense pressure to join the herd is what distinguishes an informed investor from an impulsive investor.
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