Capitalising on market psychology

Please note: All data referenced in this article are sourced from Bloomberg unless otherwise stated, and are accurate at the time of publishing.

Key points

• Financial markets, like individuals, exhibit biases. This can lead to periods of excessive optimism or pessimism. In turn, it affects their mood over the investment outlook, which can create opportunities for investors
• Understanding what drives market expectations can help to inform your investment decisions or in forming a view on the outlook for markets
• For instance, US equities have rallied of late. However, markets can be fickle. A surprise headline could easily spark a swift correction. That’s why defensively-positioned – and well-diversified – portfolios can often provide a valuable anchor in choppy waters
• And given the many geopolitical events currently flashing red, preparedness becomes a powerful tool by which to navigate market cycles with confidence

The impact on financial-market sentiment this year of geopolitical flashpoints, the pace and quantum of interest rate cuts, and outcomes of imminent government elections is likely to be large. 

The importance of investors understanding their own behavioural tendencies when making investment decisions is something we have written about before. Timeless investing principles, coupled with strong behavioural resolve are, in our view, key ingredients for long-term success.

Psychology also drives the market

It is not just investor behaviour, which is driven by psychology, but also market sentiment that matters. Given that markets consist of individuals prone to their own biases, broad market behaviour can be somewhat predictable (albeit nothing is ever guaranteed). 

To illustrate this, consider an individual’s typical reaction to news and narratives, creating a predictable cycle of emotions. 

Assume good news is permanent; then pay less attention to bad news; then ignore bad news; then deny bad news; then panic at bad news; then accept bad news; then assume bad news is permanent; then pay less attention to good news; then ignore good news; then deny good news; and finally accept good news.

The cyclicality of market behaviour provides opportunities

Just like individual investors, the market goes through predictable behaviour patterns, in turn creating potential opportunities. In general, markets undergo cycles of rising values with positive sentiment, and falling values with negative sentiment along their long-term trajectories.

While exact timing and duration of these shifts are difficult to predict, we can be confident – as market watchers and students of history – that they will occur. 

This can be useful for individual investors to avoid falling into common investing pitfalls, but also in capitalising on opportunities. Broadly speaking, there will be times when the market appears overly optimistic or pessimistic. Successful long-term investors recognise this and monitor it for opportunities without allowing market sentiment to distract them.

Capitalising on market moves

We have frequently highlighted the importance of getting and staying invested for the long term, benefiting from the long-term directionality of markets and allowing wealth to compound. 

Much short-term news flow can be noise, potentially derailing investors from achieving their long-term goals. That said, macroeconomic changes may necessitate shifts in your portfolio allocation or provide tactical opportunities. In terms of the latter, investors should also be aware of the role of market sentiment and positioning.

Importantly, in order to identify opportunities it is important to understand market expectations for key market drivers. For instance, the path of US interest rates is likely to play a big role on what happens in markets this year. 

Making sense of market expectations

With interest rate peaks seemingly having been reached in the US and Europe, discussion is now around cuts. Whilst the market has long expected rates to ease in 2024, and to see cuts in the spring, central banks are espousing a more cautious line. Short-term market moves occur when data and central bankers’ comments affect those expectations.

This creates opportunities and risks. For example, we are seeing volatility in markets in response to macro data releases significant in the hard versus soft landing debate, leading to revisions of rate-cut expectations and subsequent moves in bond yields. 

Last year saw opportunities for investors to lock in higher yields, as rates rose. In turn, this year could see opportunities at the longer end of the yield curve, where investors can benefit from capital gains. 

In our view, with the jobs market remaining tight and inflation still above target, it will likely take a significant surprise for the US Federal Reserve to cut interest rates in the first half of the year.

Are expectations too optimistic?

Equity markets have continued to rally, and the bullish sentiment regarding a soft landing poses the risk of a pullback on data which significantly alters that expectation. Extremely bullish sentiment can lead to sharp market reversals on any small disappointment, with price action driven more by the surprise element than levels actually reported (see chart). 

At such times, a more defensively positioned portfolio could be called for. At the same time, a pullback can provide an attractive entry point for a long-term investor.

Sentiment amongst individual investors is bullish

AAII sentiment survey overlayed with S&P 500 performance. Above the line sentiment is bullish, below is bearish

A core-satellite approach to long-term investing

But how does this knowledge translate into opportunities for the individual investor? Shocks can provide opportunities to deploy dry powder when investors are unduly pessimistic or hedging in the face of exuberance. 

Implementation ideas could involve a rules-based approach to topping up when a market index reaches a particular level, or instruments which are structured to allow an investor to benefit from those levels being reached.

A core-satellite investing approach provides the foundations to stay invested through market cycles, providing the headroom for mitigating risks and capitalising on short-term opportunities.  

Given the number of geopolitical events flashing red and potential for extreme market moves this year, as ever, a diversified portfolio appears to be called for. Through all the market unpredictability, a well-diversified portfolio allows investors to be compensated for risking their capital, throughout market cycles.

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