Markets are in an Overreactive Cycle

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Every tiny bit of information can cause enormous swings and changes in course.

Investors act like sugar-starved kids receiving candy; they grab it with joy, only to wail when it is taken away.

The treats arrived on Monday as some tamely negative economic news. The manufacturing index from the Institute of Supply Management came in somewhat lower than expected. As wagers rose that the Federal Reserve would raise interest rates less vehemently, this led to an unusual rush to acquire bonds and equities.

The high persisted into Tuesday as bond rates kept dropping and equities started the day well thanks to a decline in job postings, a symptom of a deteriorating labor market.

The issue is that single data points rarely provide the markets with long-term nourishment. If the candy is retaken, as has happened multiple times in the last several months, the needs run the possibility of a meltdown. Even worse, if it appears that a recession is approaching, the real bad news is good news trend will reverse, with bad news once again being terrible news.

Economic indicators have surpassed other market-moving elements in prominence for a good reason. Investors are right to be concerned that the Fed will hike rates far higher to squelch inflation, which will also kill the economy. Interest rate expectations mostly influence stock price movements.

That makes sense, but the issue is that the market takes economic figures as gospel truth even when they fluctuate from month to month. Any one data point can cause significant swings and direction changes. As a result, overreactions become far more likely.

For such a minor change in the ISM, Monday’s rise was significant. Benchmark 10-year Treasury rates fell by 0.15 percentage points, tying with last Wednesday’s surprise government bond purchase by the Bank of England for the largest decline of the year. S&P 500 increased by 2.6%. Contrast that with the ISM data from the beginning of July, which missed the consensus expectation by a larger margin than it did on Monday but only caused Treasury rates to drop by 50% and equities to climb by 1%.

According to Credit Suisse’s senior U.S. equities strategist Jonathan Golub, the decline in Treasury rates is astounding.

The movements in the opposite direction, which occurred in June and September due to somewhat higher-than-expected inflation rates, were as severe. Unexpectedly strong inflation in June caused a significant two-day selloff. In September, two-year rates increased by 0.19 percentage points, while inflation was recorded at 8.3% rather than the forecasted 8.1%.

Why are markets so sensitive to information often seen as a rough indication of the economy to be interpreted in light of other reports? These are the three hypotheses:

First, as the Fed keeps an eye on the statistics, so should we. Jerome Powell, the chairman of the Fed, has made it plain that the central bank is examining reported data rather than relying on its models. Interest rates haven’t been so impacted by economic data released in between Fed meetings since the early 1990s. Since interest rates are already having a disproportionately large impact on markets, data that is believed to be affecting rates should also significantly impact prices.\

Liquidity is a poor second. Prices move more on bursts of buying or selling because traders and market makers are less willing to take risks due to volatile markets and tighter monetary policy. Prices are anticipated to fluctuate more as well: The implied volatility of U.S. bonds, as measured by the ICE BofA MOVE index, reached a high amid last week’s U.K. chaos not seen since the first pandemic lockdown in 2020, and before that, the financial crisis of 2008-09.

Third, there is a general fear of something breaking thanks to the Fed tightening, which makes everyone much more focused on the short term and more sensitive to potential problems. Last week the British government bond market cracked and had to be saved, and unfounded online rumors on Monday hammered Credit Suisse’s shares and bonds.

“Nobody wants to take risk in this environment because one little tweet or one little downdraft can create chaos,” said Vineer Bhansali, founder, and chief investment officer of Newport Beach-based hedge fund LongTail Alpha. “When something is happening, nobody wants to be in front of it.”

These can only be theories, though, and none is entirely satisfactory. But as long as everyone else is focused on economic data, anyone who cares about short-term performance must also pay close attention to the data. At the very least, investors should recognize any given economic report’s inherent unreliability and the risk of market overreaction. Lollipops are nice but don’t provide real sustenance.

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