When Fear Enters the Market

Investors Risk Aversion (Fear) Impact on Markets

In recent times, conditions in the financial markets have been extreme and interpreting markets in these conditions can be misleading. This is due to the fact that investor risk aversion has been a key driver of market performance rather than underlying investment fundamentals as new waves of fear have dominated markets over the past few months.

In May and June, fears rose as European sovereign debt contagion concerns increased, as did fear of double dip recessions, and a possible slowdown in China. Risk tolerance fell, and the markets followed.

In July markets fared better as fears subsided, however this reprieve was short lived. In August, anxiety regarding Europe’s outlook and China’s imbalances returned, along with the increasing likelihood that the US will require further stimulus.

When fear comes to town all risks go out of favour. Share prices fall, credit margins rise, the value of almost anything with leverage falls, commodity prices fall, and ‘risky’ currencies, including the Australian dollar, also tend to fall.

In this kind of environment it looks like investment fundamentals don’t matter. These doubts lead many to flee sound strategies at exactly the wrong time, and invest in assets seen to be ‘safe’, which then become expensive.

Will the rally come back?

The recent bout of extreme risk aversion has diverted attention from the fact that many of the ‘fundamentals’ are getting better, not worse. Consider some of the key ingredients needed for a sustainable rally in the sharemarket:

Low prices

Positive earnings expectations

Results that meet or beat

 

Opportunities now exist in both the Australian and global sharemarkets to invest at attractive prices in quality assets that would normally command a premium. On a forward price to earnings basis, the Australian sharemarket is trading at a 17 per cent discount and the global sharemarket is trading at a 24 per cent discount. Price (source: AXA Australia). These anomalies must eventually realign.

Profit results look positive

We are now largely through the June quarter reporting season, where generally, reported profits have met expectations. In the US market for example, around 85 per cent of the companies reported to date have met or exceeded profit forecasts. In Australia, results are a little more mixed, but more than 70 per cent of companies that reported have met or exceeded earning expectations.

What this means for investors

The fundamental drivers of asset class returns, or features affecting value will ultimately be reflected in prices, but not when markets (investors) are preoccupied with risk. The perception that fundamental based strategies aren’t working adds to already heightened levels of investor concern, and reinforces the destructive investor behaviour that we have seen repeatedly through previous cycles.

Typically the pattern of investment flows during bull markets sees more money flowing into equities than bonds. When markets fall, money flows out of equity markets and into bond funds. The result is a ‘buy high’ and ‘sell low’ strategy – a sure way to destroy value.

Long term investors are generally exposed to fundamental factors. Distortions created by the dominance of a single factor, such as risk aversion, can last for extended periods, but not forever. Investment in fundamentals pays off if given the time to perform.