Recent reaction by markets to the most feared news – RBI governor resigning and BJP loosing the state elections, was surprising. No one in their dreams would have thought that markets will react positively to such extreme shocking and negative news.
While we cannot exactly know why this happened, but definitely there’s is something to learn from this unusual event. I came across a great piece in a memo by Howard Marks and I have used it as a reference to put things in perspective.
Data and its interpretation
Often we see market participants reacting positively to data and events which otherwise were expected to have negative impact, and react negatively to data and events that were suppose to have positive impact. This happens due to skewed interpretation of data and events by market participants.
Here’s how investors interpret data and react to events when optimism is at peak – which usually means the market has been rising continuously:
Data: Interpretation – market reaction
Strong data: economy strengthening — stocks rally
Weak data: RBI likely to ease — stocks rally
Data as expected: low volatility — stocks rally
Strong credit growth: business conditions favorable — stocks rally
Weak credit growth: bad news out of the way — stocks rally
Crude Oil spikes: growing global economy contributing to demand — stocks rally
Crude Oil drops: more purchasing power for the consumer — stocks rally
INR plunges: great for exporters — stocks rally
INR strengthen: great for macro economy — stocks rally
Inflation spikes: Demand improving — stocks rally
Inflation drops: improves quality of earnings and rate cuts — stocks rally
Of course, the same behavior also applies in the opposite direction. When sentiments are negative and markets have been falling for a while, everything is capable of being interpreted negatively.
Strong economic data is seen as likely to RBI increasing rates, and weak data is interpreted as companies will have trouble meeting earnings forecasts. Rising crude will hurt economy and plunging INR will increase external risks.
Interpretations are more powerful than data
In other words, it’s not the data or events; it’s the interpretation that is more important. And that fluctuates with swings in psychology. At the greatest extremes of optimism or pessimism, a process can take on the appearance of a virtuous or a vicious cycle.
When events are predominantly positive and psychology is rosy, negative developments tend to be overlooked, everything is interpreted favorably, and things are often thought to be incapable of taking a turn for the worse. The logic supporting an expectation of further advances appears irresistible; past constraints and norms are ignored or rationalized away. The potential for gains comes to be viewed as infinite. Asset prices rise, encouraging further optimism.
But on the other hand, when things have been going badly for months or years and psychology is highly negative, it’s the potential for improvement that can be forgotten. Unpleasant events are emphasized and positive ones are ignored. The case for further deterioration seems rock-solid, its error can’t be imagined, and now it’s the downside that seems to be unlimited. Prices fall, resulting in further pessimism.
The virtuous circle and the vicious circle are both unrealistic exaggerations. What can only help in such situation is thinking rationally and ignoring the psychology of the market participants.