Why We Don't Trade Macro Events
2016 was a year for the stock market record books. The year opened with the worst first 10 trading days in recorded history. There has been significant research showing the correlation between how the stock market performs in January and how it performs for the year. A down January typically leads to a down year, and vice versa. But the market ended up ~9.6% in 2016.
In January, the underlying fear was that China was on the precipice of a major banking collapse that would exceed the pain felt in 2008 in the United States. In early February, a very well-known hedge fund manager who made hundreds of millions correctly calling the 2008 collapse in the U.S. released an extensive letter showing his analysis of China, why he was short (betting against the market), and why he had sold almost all of his U.S. stocks as well.
But suddenly, without any real rhyme or reason, a few days after the fund manager’s China report came out, the market began rallying on February 12th and retraced all of its losses by mid-April.
In June, going into the Brexit referendum vote, clearly everyone believed the odds favored a “remain” outcome rather than a “leave”. The odds makers in London showed the odds over 75% that the UK would vote to remain part of the European Union. The night of the vote, it became clear the people had voted to leave and the market started to crater. The market dropped ~6% over the next two trading days, but then started to aggressively rally and was back above its prior highs within the next 3 weeks.
While almost no one correctly called the Brexit vote, those who did bet on the market going down and likely lost money as they probably didn’t cover their bets in only two days.
We saw a very similar reaction to the US election. The night of the election, with it becoming clear to America that Donald Trump would become the next president, the futures market (the afterhours market that trades around the clock) went “limit down”. Limit down means it was down as far as the exchanges will let it fall in one day, which in this case was 5%. These rules were setup to help calm violent markets.
We started to receive texts and emails from other money managers discussing how we all need to prepare for a collapse of the market. But when the market opened the next morning, it opened down significantly and then started rallying aggressively. By the end of the second day it was back above where it was before the election, and rallied an additional 9% over the next month.
Once again, almost no one correctly called the outcome of the election, and those who did likely lost money… even though they were right!
Why does this happen? Because the market is a complicated machine of human emotions and expectations, some rational, some irrational. In hindsight, it appears so many people sold going into the election that significant cash was sitting on the sidelines ready to be re-invested. With Trump being elected, investors began to actually analyze the economic impact of a Trump presidency and decided: i) lower tax rates would be good for corporate profits (higher earnings typically equates to higher stock prices), ii) increased spending would increase the fiscal deficit (bond prices went down on the expectation of lower creditworthiness of the U.S. government), and iii) financial deregulation would be a boon for banks (stocks of financial companies rocketed higher).
Can this analysis be done ahead of these macro events and therefore make trading them a profitable endeavor? It can. However, the economic analysis is not the hard part. It is the behavioral analysis of what is already expected and priced into the market that is downright near impossible. Much of the macro analysis is already known by so many other market participants, so how can you tell when it is already factored into stock prices or not?
If everybody knows Apple is going to have a killer quarter and it has a killer quarter, the stock doesn’t go up much. It only moves significantly higher if the company reports numbers materially above what is expected. Expectations are the key to trading on any single event, whether macro or micro. With research it’s possible to get a gauge on expectations for individual company events (but even this is very challenging and not recommended). But to try to understand the expectations for everyone involved in the entire market, it’s a money-losing recipe.
Warren Buffett has repeatedly admitted he doesn’t have the ability to consistently make money this way. There are only a few billionaire investors we know who can. If Warren Buffett can’t do it, we can’t, and we don’t think you should try either.
The best approach is one of two avenues:
- Active approach: Buy individual companies that you understand with good long-term prospects and honest and trust-worthy management teams at a low enough price that even if you are wrong you will still make money. Typically you want to sit with these holdings for multiple years.
- Passive approach: Buy low-cost index funds and sit with them for decades. Never try to trade in and out of these based on macro events.
Either approach can be effective, but trying to time and trade macro events is not.
All the best,
Your Fortis Capital Management Team