UTS Finance Professor Talis Putnins highlights three reasons why stock markets are increasingly decoupled from future economic conditions.
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The International Monetary Fund recently warned of a disconnect between financial markets and the real economy, as it forecast a deep global recession in 2020 due to the coronavirus pandemic.
While stock markets around the world initially plunged 35% in March, they have since sprung back an optimistic 32%, despite a flow of bad economic news.
So are the markets ignoring reality, or does this mean we can expect a quick economic recovery?
Drawing on recent research, UTS Business School Finance Professor Talis Putnins highlights three factors that help explain what might be driving financial markets.
Passive investing and rigid asset allocations
“Markets are good at forecasting in many contexts, and they often give very accurate predictions of what's going to happen in the future,” says Professor Putnins.
“But it's important to understand the subtleties of different types of market efficiency – when markets can be efficient, and when they can show signs of inefficiency.
“What our research shows is that markets are far more efficient at the micro-level, in relative pricing, than they are at the macro-level, which is the absolute market-wide valuation.
“Stock markets are getting better and better at pricing stocks relative to one another, for example ANZ compared to BHP, but worse at setting market wide valuation at levels that correlate with future economic activity.”
Increased passive investing, where investors buy and hold index funds for the long term, is one of the factors driving this reduced efficiency in market-wide valuations, explains Professor Putnins.
Delegated funds management, and in particular rigid asset management allocations, such as 60/40 portfolios that hold 60% equities and 40% fixed income is another driver.
"This is because when markets crash and the equity value declines, a fund with a 60/40 asset allocation will mechanically be forced to buy stocks, irrespective of the future economic outlook," he says.
Altered risk perceptions
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The second factor potentially driving markets is a perceptual bias that leads people to underestimate risk following extreme market volatility.
“Consider the effect when you walk from outside where it's sunny into a poorly lit room. The room will seem really dark at first, but then after a while, you adapt to the level of lighting,” says Professor Putnins.
“This is an example of perceptual bias that happens when a human is shifted away from an environment with a very strong stimulus into a more normal environment,” he says.
Professor Putnins and colleagues tested this bias effect in relation to financial markets.
First they conducted a lab experiment where they took people through trading simulations, controlling the level of risk and volatility, and observing their perceptions of risk.
And second, through an analysis of the pricing of S&P 500 options, they examined how implied volatility relates to future volatility, to uncover these distortions.
“The key result that comes out of our studies is that people have a tendency to underestimate risk following periods of very high volatility,” says Professor Putnins.
“When you drop from an extreme level of volatility, which we saw in late March, to an elevated but less extreme level, people feel like the environment is safer than it actually is,” he says.
“This false sense of safety results in excessive optimism, which inflates valuations, despite a gloomy economic outlook. Eventually, however, perceptions catch up with reality”.
The paper: The 'Waterfall Illusion' in Financial Markets: How Risk Perception Is Distorted After Exposure to Extreme Risk, has been published on SSRN, an open-access research platform used to share early-stage research.
Central bank interventions
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The third major factor influencing stock markets is the shift away from free markets to “Fed markets”.
“These days, the biggest market participant is not a hedge fund. It's the central bank,” says Professor Putnins.
“We've got the US Fed, the European Central Bank, the Reserve Bank of Australia, the Bank of Japan and the Bank of England all intervening in markets.
“The US Federal Reserve asset purchases have been at an unprecedented rate. The balance sheet has gone from $4 trillion to about $7 trillion in the space of about one month. That's 33% of GDP.
What does this do to markets?
“Our early analysis shows that when markets have a major decline, that tends to be followed by strong balance sheet expansion by the US Federal Reserve, two to five weeks after the decline.
“Subsequently, that asset purchase activity by the Fed tends to be followed by a market rebound, from zero to three weeks after the activity,” he says.
The researchers also used modelling to explore what stock market prices would look like if the Fed had not intervened.
The research paper: From Free Markets to Fed Markets: How Unconventional Monetary Policy Distorts Equity Markets, is also available on SSRN.
“If we take the Fed asset purchases in March 2020, and translate them according to our model as to what the estimated impact of that is on the S&P 500, it's about a 13% increase,” says Professor Putnins.
“This is telling us that the Fed’s actions can explain over a third of the bounce in US stock markets since the March lows.
"So central bank actions are contributing to rebounds in stock markets precisely at the time when the economic outlook is looking gloomy. However, balance sheet expansion cannot continue indefinitely," he says.
Passive investing, the underestimation of risk following extreme volatility and the role of central banks are just some of the factors suggesting stock markets are increasingly decoupled from future economic conditions.
So a strong market recovery doesn't imply a quick economic recovery, and it could even pose a threat to the economic stability, once investors blink a few times and adjust to the new reality.
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