Stock Markets Don’t Care About War

07.04.2017 • United Kingdom

By Dan Denning – Southbank Investment Daily (Great Britain) –

Today’s letter is going to begin with the premise that the stockmarket doesn’t care about war. It will keep on rising no matter what, driven by something else more powerful. And just to be clear, I’ve borrowed that idea from Akhil Patel, who expressed it recently in his 2017 forecast issue of Cycles, Trends and Forecasts.

I haven’t asked him yet. But the more I think about it, the more Akhil’s theory of asset prices – that they’re driven by an underlying cycle linked to land prices – is at odds with the idea that asset prices are mean reverting. That idea, that stocks spend prolonged periods of overvaluation before reverting back to a historic mean, is what’s behind all the academic valuation models I’ve covered in the last few weeks.

And you can see why mean reverting valuation metrics make sense, at least at a psychological level. Investors think about the future, about expected returns and about their required rate of return to meet some distant future financial goal. It’s all about how much you’re willing to pay now for future expected profits.

But remember, if Danny Kahneman and Amos Tversky are right, at some primal level we all fear losses more than we desire gains. Mean reversion – when stocks go from overvalued to undervalued (also known as a crash when the process begins from elevated levels) – is when loss aversion kicks in.

Not to get too bookish, but in mean reversion of the bear market type, your expectation of future returns suddenly collides with a cold ball of fear in your stomach. The fear is that you’ll lose everything you’ve worked so hard for if you don’t sell, and sell now.

It’s an odd dynamic where past performance doesn’t guarantee future returns. But it does influence perceptions of value, which in turn influences behaviour and attitudes toward price.

But I digress. Let me suggest that there is another theory of asset prices that is not based on mean reversion. It’s based on cyclicality. And it currently suggests a second phase to the current cycle could see the FTSE rise to 15,000 by 2026.

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