About That Wibbly Wobbly Market

Why are stocks just bouncing around?

That’s the question on many investors’ minds as global stocks continue their volatile yet sideways year. The common views are that stocks were just bound to lose steam after such a big 2013, especially with the Fed “pulling support,” or it’s a bursting biotech and social media bubble. (Wrong and wrong, in our view.) But a new explanation has surfaced recently: Some say the market is driven by hedge funds and professional managers, and their changing tactics mean we’re in for a long period of “grinding” volatility and lackluster gains. Color us skeptical. For one, the pros don’t influence market returns anywhere near to the degree these folks suggest. Moreover, bouncy-yet-flat stretches are fairly typical during bull markets. To say we’re in some new normal where stocks yo-yo in a narrow range is to say “it’s different this time”—always a fallacy.

The “it’s the pros’ fault” argument claims hedge funds and other professional investors are swapping broad, market-like positioning for narrower concentrations and more frequent trading, selling in and out of different stocks as they rise and fall—effectively establishing a floor and ceiling on prices. If you’re asking why that last bit would be true, you aren’t alone—it flat ignores how markets work. The trading decisions of a few managers don’t much matter to overall market returns. After all, for every seller, there is a corresponding buyer. For every pro dumping a stock because they think it’s a dog, there is someone else—individual or pro—who thinks it’s a bargain with plenty of potential.

What drives prices, always and everywhere, is supply and demand. Demand doesn’t have much (if anything) to do with whose dollars are chasing stocks—something those saying hedge funds are moving the markets because retail investors, pension funds and mutual funds are “bit players” miss. (They also miss that these groups are far from bit players.) Demand is simply a matter of how much investors of all stripes are willing to pay for the future earnings of publicly traded companies. That willingness is there. Supply, meanwhile, is shrinking. Net issuance (gross issuance minus buybacks and cash-based M&A) has contracted throughout this bull market, and the pace of contraction actually accelerated in Q1. The result is investors competing more for an incrementally scarcer commodity—a recipe for rising prices.

Looking ahead, equity demand should remain firm. Corporate earnings have taken a bit of a breather in Q1, but they appear set to accelerate over the rest of the year, driven by rising revenues. The global economy is growing—despite a small but high-profile slowdown in China—with the developed world looking increasingly strong. Global trade is rising, and protectionism remains at bay. Politics are benign, with market-oriented reforms progressing in many developing nations and gridlock preventing radical change in most already-competitive economies. Unrest and even war plague some smaller developing nations, but investors largely seem to realize these tragedies shouldn’t much impact global commerce.

So why are markets all bouncy? In short, sometimes, that’s just what markets do. In the long run, markets pretty efficiently weigh all extant fundamentals. But over short periods, markets can behave quite irrationally. No bull market is a straight shot up. They have corrections, smaller pullbacks and even long, bouncy, overall flat stretches. It’s the market’s way of confusing folks—one of its favorite pastimes. Exhibit 1 shows the MSCI World Index during this bull market, with some of the wobblier “flat” stretches highlighted. Some, like 2010 and 2011-2012 involved corrections. Others, like the mid-2013 stretch and the current one, didn’t. The current stretch isn’t even especially violent—that headlines seem to think it is says more about the world’s short memory and difficulty calibrating volatility than anything else. It’s a statement on psychology, not a sign of where markets go next.

Exhibit 1: MSCI World Index in This Bull Market

Source: FactSet, as of 04/28/2014. MSCI World Total Return Index (Net), 03/09/2009-04/25/2014.

None of these wobbly phases have derailed the bull, and there isn’t any reason the bull should end now. Volatility and erratic trading don’t kill bull markets—they’re just normal. Bulls usually run on until euphoric sentiment surpasses fundamentals or stocks meet a huge, unseen negative. Neither is true today, with skepticism tugging hard at investors’ emotions and most risks either too widely discussed or too small to disrupt the bull.

Those who argue otherwise—and who base their claims on volatility and the pros’ behavior—effectively argue it’s different this time. As Sir John Templeton once quipped, those are the four most dangerous words in the English language. Those who utter them forget history. At times like this, they forget all the volatile stretches bulls have endured for decades. At peaks, they forget bulls always end; at troughs, they forget bulls always begin anew. That’s not to say dogged contrarianism is a winning strategy—it isn’t—but hearing “it’s different now” is usually a good cue to consider how conventional wisdom and the consensus view might be wrong.

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