Friday, March 9, 2018

The psychology of the financial markets

Consider this. Someone scares you by inflating the likelihood of an imminent disaster. If the disaster does not materialise, you are relieved and happy. But does the happiness have any real basis?

The same applies to financial markets. They respond favourably to a positive news about the economy. But it is perhaps not incorrect to say that it responds even more positively in relief when an anticipated negative news does not materialise. Consider the following instances
  1. The collapse of global financial markets in the aftermath of the GFC and its impact on the economy in the form of a repeat of Great Depression
  2. Catastrophe in Europe with the Greek and Irish crisis spilling over to Italy and Spain, thereby causing the unravelling of the EU itself
  3. The debt-bomb ticking in China would bring down the entire economy
  4. The end of commodity cycle, global economic slowdown, and imminent collapse of China would herald the end of the emerging market story
  5. The exit from quantitative easing would lead to a rise in rates and devastate debt-laden governments, corporate sector and households
  6. World economy has entered a deflationary loop and negative rates are here to stay
  7. In the aftermath of Brexit, far-right parties will emerge as important players in the political scene across Europe
  8. The Trump Presidency will lead to protectionism and trade-wars, exist from NAFTA, American isolationism, and global economic collapse
It cannot be denied that there was a likelihood of each one of the above. And the consequences could have been bad. But what is debatable is whether they were as grave and imminent as was made out to be by public commentators and academic scholars. I am inclined to believe that their views of these scenarios were painted as doomsday prophecies in the financial press and opinion makers.

These narratives shaped expectations and prayers that they not materialise. In the circumstances, once the likelihood of their incidence declined, markets responded with relief. In fact, once the danger passed over, markets rebounded excessively. 

Over the last few years, each one of these dangers have receded, thereby boosting market confidence and the associated animal spirits. The extended bond and equity market booms owe a lot to animal spirits engendered by the market relief from having avoided these dangers. But do they have any real basis?

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