Thinking Markets Are Simple Might Be Costing You Money 2
Another, more pernicious example of reductive thinking is how people love to attribute single factors to explain price movements.
You’ve definitely heard it before, stuff like: “XYZ stock went up because it reported higher revenue”, or “Treasury yields are lower because of safe haven buying”.
These statements do more harm than good because they cause traders/investors, especially inexperienced ones, to 1) confuse correlation with causation, and 2) believe that markets are simple and easy to understand.
In the case of 1), a lot of times, markets will spike on a headline, such as “XYZ notches up record revenues”, which leads to people conflating the two events.
But correlation is not causation, and if one wants to attribute a fundamental reason for prices moving higher, there are so many other factors involved. Not least XYZ’s net income, margins, and costs.
It is far more likely that the buying came from a mixture of people. Those who truly believe that only revenues matter, those that assume higher revenues means good overall earnings, and those looking to profit from all the buying the people in the first two groups were doing.
Not a single, simple, factor after all.
In the case of 2), reading reductive statements put out by analysts and the financial media only reinforces people’s natural tendency to think in reductive, simple cause and effect terms.
Because of A , B will happen. The simplicity and straightforwardness of such causal statements are after all, quite beguiling, and the human psyche likes to latch on to them as concrete truths.
Unfortunately, complex systems do not work in linear causal ways.
For example, a statement like “Treasury yields are lower because of safe haven buying” encourages people to think of Treasuries only in terms of it being a “safe haven”. But the truth is, Treasuries only became the go to “safe haven” asset relative to stocks at about the start of the new millennium.
The point here being that market relationships are not constant.
Also, thinking of Treasuries as safe haven assets views the asset class only from the perspective of portfolio management, whereas Treasuries serve a much larger role in the financial system.
They are also used as collateral in the massive global repo market that international banks and corporations use to quickly gain access to USDs. This effectively makes USTs a de facto global currency, and the reserve asset of choice for global Central Banks.
Furthermore, their role at the nexus of global repo and USD funding markets means Treasuries are affected by forces far more global, diverse, and complex than portfolio managers’ need for a “safe” asset.
Forces like global growth prospects, offshore USD liquidity, and international Central Banks’ reserve accumulation, to name a few. These in turn are part of two-way feedback loops with other factors, such as global trade volumes, commodity prices, and inflationary/deflationary forces in foreign economies that are too dependent on offshore USD funding.
Again, not a single, simple, factor.
To be concluded…
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