The Bear Market Paradox

The Bear Market Paradox

Michael Covel pointed out a great quote in a recent episode of his popular Trend Following podcast.  The quote came from a white paper authored by Graham Capital Management (emphasis my own):

…“events” do not happen in a vacuum. They are often defined as “events” because
markets are already preconditioned to fear bad news. This is the reason trend following rarely gets caught on the
wrong side of an “event”. Additionally, the stop loss trading style will limit exposure when it does. When equity
markets reach strong negative consensus regarding its long term outlook, any reinforcing news will drive the trend
further. The series of corporate accounting frauds in the second quarter of 2002 are the “events” of the latest bear
market which helped drive the market down even further. In an optimistic economic environment, these
occurrences might have been perceived as aberrations rather than symptomatic of a larger problem.
Paradoxically, bear markets cause “events” more than “events” cause bear markets.

Trend Following: Performance, Risk and Correlation Characteristics, Graham Capital Management

The idea that it is possible for bear markets to cause events rather than events being the catalyst for downturns is an important one.  Last week I cautioned readers not to take any statistic too seriously when it comes to making an investment (Stock Market vs Statistics).  No matter what the statistics say, the market is going to do what it wants.  At times, the market will go down just because it’s already headed that way.  Explanations as to why usually pop up later as we search for answers.

In the past year, Chinese stock markets have experienced a bubble and a crash.  The Shanghai Composite is down nearly 40% from its YTD high.  Why did this happen?  Although there are clear signs that the Chinese economy is slowing, that is not the reason for such a drastic pullback in the markets.  These markets were driven by emotion.  There was a frenzy of buying as stock prices soared nearly 100% in just a year’s time, and then there was panic selling as many investors rushed to the exit as prices fell.

In his piece entitled The China Syndrome: Lessons of the A-Shares Bubble, Jason Hsu of Research Affiliates said the following about the China situation:

I suggest that the Chinese bubble is not primarily an economic crisis. It is better understood as a social crisis occasioned by a massive wealth redistribution that disfavors average investors.

Jason notes that although the market decline may not have been caused by fundamental issues, it will likely have economic consequences.

The more the market is dominated by the irrational exuberance of naïve speculators, the more and the longer prices will deviate from rational valuations. The consequences of a low-quality equity market are severe; that’s why some economists have endorsed regulation and even intervention.

Circling back to the paradox of bear markets.  In the aftermath of the Chinese stock market bubble, it will be interesting to see what “events”, the crash may cause.  Negative data will be viewed as more negative and positive data will be viewed as an aberration.  So contrary to what most would assume, price is often the tail while news flow or an event is the dog.  Don’t be fooled by what the statistics are telling you.  Keep an open mind and always be aware of which way that tail is wagging.

Tim Brennan

Comments are closed.