Stocks’ Calm Isn’t Irrational

If you're watching this, markets are too. Photo by SeongJoon Cho/Bloomberg/Getty Images.

Volatility has been largely absent in recent weeks, much to media's chagrin. On Tuesday, after President Trump vowed "fire, fury, and frankly power the likes of which this world has never seen before" in response to further North Korean provocations, the S&P 500 had its biggest drop in a month-a whopping -0.2% decline.^[i] When the sabre-rattling escalated further Wednesday when Kim Jong-un threatened Guam, the S&P 500 dropped just -0.04%.^[ii] Thursday's drop was larger at -1.4%, but perhaps still not the sort of freakout most assumed an apparent nuclear standoff might cause.^[iii] Some argued the calm is because it's impossible to price in a potential "extinction event." Others called it a sign of complacency. But in our view, markets are doing what they always do-pricing in all publicly available information, including risks, and weighing probabilities. While stocks can behave irrationally in the very short term, presuming they're wrong about something is fraught with peril.

Reading into market movement (or lack thereof) is nothing new-we have an informal running series on the topic, marked by titles beginning with "Searching for Meaning in ..." The investing world's tendency to overthink these things seems to stem from an ingrained belief that certain developments should have predetermined market impacts. That ignores the simple truth that short-term market movement can happen for any or no reason. Is there any logical reason stocks should or shouldn't have fallen less on Thursday than they did on May 18, when the DoJ named Robert Mueller special counsel for the Russia investigation? Trying to assign inherent expected volatility to current events will do nothing but give you a headache.

None of the things investors are allegedly complacent about this week are new. From the debt ceiling to North Korean threats, all have hogged headlines for weeks, months or longer. Individual developments like the "fire and fury" remark and Guam threat might heighten attention on North Korea, but the Hermit Kingdom has been testing increasingly (allegedly) more powerful missiles most of this year. And yet US and world markets have been largely calm and up. Stocks were also up in 2013, when Kim Jong-un announced he considered the 1953 armistice null and void.

Exhibit 1: A Very Calm S&P 500

Source: FactSet, as of 8/9/2017. S&P 500 Total Return Index from 12/30/2016 - 8/8/2017. Indexed to 100 at 12/30/2016.

Exhibit 2: An Unfazed MSCI All Country World Index

Source: FactSet, as of 8/9/2017. MSCI All Country World Index with net dividends from 12/30/2016 - 8/8/2017. Indexed to 100 at 12/30/2016.

To those who might argue this is evidence of long-running complacency, consider South Korea. If anyone is aware of the risks of nuclear conflict, it is investors on North Korea's doorstep. If any companies are particularly vulnerable to Kim Jong-un's whims, it is South Korean firms headquartered in Seoul, which is under perpetual threat. But South Korean stocks are up 32% YTD.^[iv]

Exhibit 3: A Surging MSCI South Korea

Source: FactSet, as of 8/9/2017. MSCI Korea Index in USD with net dividends, 12/30/2016 - 8/8/2017. Indexed to 100 at 12/30/2016.

Is this complacency, or a rational weighing of risk? Anecdotal evidence indicates South Korean investors aren't ignoring the dictator next door. Instead, they view Kim's bombast as a buying opportunity. Said one, "[South Korean] investors know from experience that geopolitical risks don't play for long." Another observed, "I usually don't think too much about North Korean risk. ... When North Korea does something provocative, it's a good time to buy new stocks at a lower price."

This strikes us as markets doing what they do best-efficiently discounting widely known information. If information is public-and especially if it's plastered on every newspaper and cable news banner-stocks rapidly price it in. Markets weigh what's probable, not what's merely possible. While hotspots like North Korea spark big fears, huge conflicts remain wildly improbable.

Moreover, markets process geopolitical drama all the time-and frequently keep rising. In this bull market, stocks have moved past numerous scares like the rise of ISIS, Israel-Iran tensions, Russian incursions into Eastern Europe, governments toppling around the Middle East, the Syrian civil war, many deadly terrorist attacks and much more. Looking back further: During the Tech boom in the mid-to-late 1990s, markets broadly rose throughout flare-ups in the Balkans, Al Qaeda attacks on US embassies in Africa, two wars between Russia and Chechnya and ongoing strife in the Congo. Or consider 2006, when North Korea test-fired seven missiles, one of which experts estimated could reach Alaska-world stocks rose 20.1% that year.^[v] 1983 was also up nicely despite a major nuclear scare that autumn. This stuff isn't new-stocks have always dealt with it.

However, investors might notice a frequent disconnect between calm markets and coverage of the danger du jour-in which speculation frequently passes for concrete forecasts, and distant possibilities as if they're 50/50 shots. We aren't saying stocks always see the future perfectly. But if headlines scream markets are ignoring such-and-such obvious threat, stocks have seen those very headlines-and priced them in already.

You can apply the same logic to the rest of today's list of allegedly overlooked risks, like an ECB taper, Brexit, the debt ceiling and others. With so much media coverage, it is impossible to say investors are unaware of them or their alleged impact. But markets reflect the wisdom, opinions and predictions of all investors. That is more brainpower collectively than any supercomputer can muster. Markets are telling us, based on all available information, that these aren't the bogeymen headlines make them out to be.

Volatility, meanwhile, comes and goes without rhyme or reason. Assigning meaning is usually futile, and even if you could identify a probable cause, it doesn't mean you should act. Even larger corrections-short, sharp, sentiment-driven declines of 10 - 20%-are fleeting, and selling after volatility raises the risk you miss the bounce.

Our advice: Whether or not volatility escalates, focus on whether your long-term financial goals require owning stocks. If so-and if the present bull market has life in it yet, as we believe it does-don't heed warnings stocks are ignoring huge risks. Markets don't get everything right all the time, but they're always pricing in probabilities. Trust them on that.