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.
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.
