Sunday, August 23, 2015

When "less-knowledgeable" Investors Assume...

Take in this excerpt from The Foreign Exchange Matrix, the excellent 2013 book by Barbara Rockefeller and Vicki Schmelzer:
In market contagion, the less-knowledgeable party knows that he is less knowledgeable and fears being cheated, so that he sells even when there is no evidence that the quality of the asset has changed.

I began this weekend's commentary by telling of the question a friend asked me yesterday. He simply wanted to know why the market sold off so hard on Friday. I think the above quote essentially answers his question.  

Here's more (the reference has to do with the late 90s Asian currency crisis):
When an investor knows he is less-knowledgeable, he assumes the more-knowledgeable parties have information he does not have, so he joins the stampede. Thus, when the presumed knowledgeable parties started a sell-off in overvalued Thai equities, it spread to other risky assets elsewhere in Asia and then Argentina and Russia, even though Malaysians, for example, complained it was unfair to be tarred with the Thai brush.

To bring the above home to today, insert China A share stocks in place of Thai equities. Here's more:
In many instances, the domestic investors were authentically more knowledgeable about their home assets and knew perfectly well that there was, objectively, no change in the conditions that should determine their prices – except that advanced country investors were fleeing emerging markets indiscriminately (in what investment managers term cross-market rebalancing).

Today, informed long-term U.S. investors are indeed "authentically more knowledgeable" about their home assets. But when a market correction is years overdue, traders will make the most of, and exacerbate, the kneejerk reaction to events that spark memories of contagions past. Even though today's circumstances are far removed from those of yesteryear's currency meltdowns. And lastly:
By assuming that emerging markets share the same market and economic risks to the same degree, the managers can transmit contagion in the form of falling prices even in the absence of directly relevant news, and sometimes between markets that do not, in fact, share the same risks.

Yep! And my the opportunities that develop when markets that do not, in fact, share the same risks sell off!

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