When people describe the reason for share price moves or shifts in bond yields, it is almost always in fundamental terms. As if every time a new piece of market-relevant information is released, investors are hurriedly updating their valuation models. This gives a pleasing sense of order to the fluctuations of financial markets, but is a poor explanation for what is really happening. Most market moves are about investors guessing what other investors are going to do.

Let’s say there is a weak employment number in the US, and the S&P 500 drops by 1%. Is that a result of investors reassessing the fair value of US equities due to an increasing risk of slower growth? Maybe. But it is more likely to be investors reacting to how they think other investors will respond to this new information.

Markets – particularly over the short term – are much like what was traditionally called a ‘Keynesian Beauty Contest’ or a guessing game where you win not by guessing the right answer, but what you think others will say the right answer is.

Does this behaviour have anything to do with changes in the fundamental worth of an asset? Yes and no. If investors are predicting how other investors will react to new fundamental information, then they indirectly care about fundamentals. However, they don’t have to. If they are just trying to predict other investors’ actions, they care about whatever signals those investors might respond to at that time. These could be relevant to the asset’s long-term value or not at all.

Also, if most people are involved in the same guessing game, then it is not necessary to predict how other investors will react to new information, but what other people in the game expect other people in the game to be doing. (It can get very circular.)

We can easily end up with a market where nobody is paying any attention to fundamentals; everyone just acts as if everyone else is.

While a lot of market activity has little to do with genuine fundamental changes in the value of an asset and even if it does it is indirect. This type of ‘guessing game’ behaviour can, however, impact fundamentals, if we bring in Soros’ concept of reflexivity.

Here significant movements in price (whatever the cause) can affect fundamentals or ‘reality’. Imagine French government bond yields are being pushed higher by investors guessing that other investors will react to a worsening fiscal situation and higher inflation. This investor-led price move can morph into a profound fundamental problem as these higher yields create higher debt service costs and increasing political pressure.

Although they can often feel entirely distinct, asset prices and fundamentals are not entirely independent of each other.

The Fundamentals Will Out

If most fluctuations in markets are not driven by investors changing their views on the fundamental value of an asset, does that mean they don’t matter? I don’t think so, they are important in a variety of different ways and over different horizons:

• To the extent that investors playing the guessing game care about fundamentals (often they don’t) then fundamentals matter even if indirectly.
  
  
• In certain situations reflexivity can take hold which means non-fundamental price moves create fundamental issues.
  
  
• In extreme situations fundamentals tend to rise to prominence  – for example, when a company is in distress its fundamental worth (or lack of worth) will matter a great deal to the price of its debt and equity.
  
  
• Over the long run, fundamentals will likely win out in defining the return of an asset. Although changes in fundamental value may tell us little about an individual short-term price move, fundamentals should be the most important element over long horizons.

When we read fundamental explanations for why markets have behaved in a certain way, it is rarely an accurate reflection of why prices have moved. Over most short horizons it is not fundamental changes in the worth of an asset that matter, but investors guessing how they think other investors will react to new information they currently deem important. At times this might be related to fundamentals, but very often it will not be.

To be successful taking these types of short-term views we need to somehow be able to predict what issues investors are currently focused on, how these issues will play out and how other investors will react to them. This is a tough ask.

For long-term investors, the fact that short-term market moves are largely the result of investors chasing each other around shouldn’t be a major concern. That is not a game we need to play. We just need to avoid being fooled into thinking that every daily or monthly price move reflects a meaningful change in an asset’s fundamental value.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

One of the most common views expressed in financial markets at present seems to be that bonds (particularly the government variety) are no longer an effective diversifier when held alongside equities in a multi-asset portfolio. These arguments are usually accompanied by a chart displaying rising stock and bond correlations, and perhaps some five-year performance numbers showing how poor fixed income returns have been. I think these perspectives get a lot wrong about the purpose of diversification and how bonds are behaving.

Bonds are doing bond things

If I had been told at the start of 2021 that over the coming years there would be several supply-side inflation shocks, substantial fiscal stimulus, inflation consistently above target and a material rise in interest rates – would I have been bearish on bonds? Even as someone who is reticent to make predictions, I am pretty sure I would have been – particularly starting from such unattractive valuations. The performance of bonds – and their changing relationship with equities – has been just what we would have expected given the starting conditions and subsequent environment.

It is odd that an asset class behaving in a way that is entirely consistent with its structural features is a reason to abandon it, or suggest it is not working. Bonds seem to be working just fine. Unfortunately, all asset classes are vulnerable to a particular set of circumstances, and the precise timing of those circumstances is usually well beyond our capabilities. This is why we diversify.

Starting valuations matter

The valuation of bonds matters a huge amount to their expected future returns, and it is also vital to their diversifying properties. Higher starting yields provide strong insulation from losses incurred due to rising yield levels, offer greater scope for yields to fall during downturns and provide better long-term returns in the unknowable future paths that lie ahead of us.

Valuations are not just about headline yields (inflation matters a lot too), but lots of pessimistic takes on bonds seem wilfully oblivious to the fact that higher starting real and nominal yields are a good thing for investors.

Don’t judge an asset class by its (short-term) performance

The powerful narrative around the ineffectiveness of bonds is classic investor behaviour. We take recent returns, build a story to explain them and then extrapolate. Using the same process to describe bonds as broken now would lead us to be incredibly bullish in 2020 – they had performed remarkably well in prior years and exhibited a negative correlation with equities, what was not to like? (Apart from valuations that is, but who cares about those?)

An approach to diversification that relies on the performance profile of an asset class through a particular period or ‘regime’ is inevitably deeply flawed. Diversification is about building a portfolio for a range of future paths that are at best uncertain and at worst entirely unknowable. Making allocation decisions that assume asset classes will replicate their behaviour from one specific (usually recent) instance leads us in the opposite direction of what diversification should be looking to achieve.

Is it just a macro forecast?

A key question about the pessimism surrounding bonds is whether it is driven by a belief that the merits of high quality fixed income as a strong, diversifying asset no longer exist at all, or is it simply a prediction that the future environment will continue to be difficult for bonds? These are easy to confuse but are very different stances.

The first is the ‘bonds are broken’ argument – which contends that bonds will not behave in the way they have historically. This is a bold call and one best tested by asking – how do you think bonds will perform in a growth shock / recession? If the answer is poorly, then someone genuinely believes that bonds have undergone a profound, fundamental change.

The second perspective is just a macro forecast. A belief that bonds will continue to behave like bonds, but that the backdrop will remain challenging – presumably because of growth and inflation dynamics. It is perfectly reasonable to hold this view, but also important to acknowledge how bad we are at making economic forecasts, and size any position accordingly.

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It is easy to think of diversification as just being about combining assets to hit some risk (usually volatility) target or to smooth the path of returns over time. While these are valid reasons for why we might diversify, at its heart diversification is really about the future being incredibly uncertain. We don’t know how the years ahead will play out and our portfolio should reflect that ignorance. We want to own assets, such as bonds, that we expect to fare well (and not so well) in a range of different environments.

It is possible that the underlying features of bonds have changed significantly and they no longer offer anything valuable to a diversified investor, but it is difficult to find evidence of this. It seems far more likely that overconfident investors are making assumptions about the future of bonds based on recent performance and overly confident economic predictions.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.