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The complex nature of financial markets creates a need to develop ways of observing its behaviour, in order to better understand the market and its interaction with the socio-economic environment. When economics and politics diverge, it becomes even more important to understand the behavioural forces that can shape the market direction.
Making a psychological picture of the market is not easy, but it does provide an important part of the puzzle that explains why markets often deviate from the “efficient” pricing model. Phenomena such as herd behaviour and the contagion of rumours help to explain why market emotion can drive prices away from efficient pricing of the underlying economic reality.
Once identified, the type of behaviour must be diagnosed, researched and interpreted in terms of the most likely market impact it will generate. The behavioural profile that can be composed of Mr. Market should however be a well-researched overview. It has to capture drivers of sentiment and expressions of crowd behaviour, and maps investor positioning and flow dynamics. The outperformance of asset classes that have benefited from previous flows can trigger additional flow by fund managers into the same asset classes. It can then be profitable to follow the herd into an investment theme that is still building, as some of these themes can last for a substantial period of time. At the same time, optimism and pessimism as well as investor positioning can get overextended after periods of one-directional moves. At some point it will therefore be wise to position for a reversal of this extended trend.
A recent development in this area is the analysis of newsflow from digital channels, creating the ability to objectively measure emotions, perceptions of uncertainty and political risk in a high frequency and timely manner. In a world where a vast amount of information and emotions are shared through digital channels, it is essential to “listen in” to the networks of financial news platforms, blogs and social media to understand how our broad economic and financial mind-set is evolving.
Our approach is to be flexible in our thinking and innovative in our use of technology. We understand that having a broad array of information is better than a narrow focus and we therefore base our asset allocation on a combination of fundamental and behavioural analysis. Aside from an essential and robust analysis of macro and corporate fundamentals, we regard understanding sentiment to be indispensable for making better-informed investment decisions.
Often we see that the two components behave very differently. While the underlying economic reality may appear robust, shifts in sentiment can cause a change in market direction that might otherwise seem counter-intuitive. While it is not always easy to identify the underlying cause of the sentiment shift, having the ability to identify it already provides valuable information.
At the start of 2016 , a period of equity market strength was followed by a sudden and sharp market reversal. Equity sentiment readings had started declining in December 2015 and by the time we started the new year these were flashing warning signs. This helped in the first days of 2016 to avoid the worst of the equity declines that followed.
On other occasions the observation that sentiment remains strong towards a sector or region gives us the ability to “look through” a soft patch in the fundamental data. We saw this earlier in 2017 where a slowdown in the Chinese data led to a weakening in emerging market fundamentals. However, this was offset by a continued strong reading from our behavioural indicators, which kept us more positive on the EM region. Actually, our position in EM equities has been one of the best performing allocation calls in 2017.
And we are continually looking for ways to learn and adapt again. To get better, more flexible and more robust in our decision-making. This means making more use of the data we have, and to look for new sources of information to understand even better the various forces at work in shaping the market, by partnering with researchers from the fields of data science, behavioural economics and human cognition. It all stems from the realisation that we always have to stay humble on what we can know and open to adapting to a future that behaves differently than the past.