Source: Stefan Krasowski
If the stock market falls sharply from here historians will attribute the drop to President Trump’s “fire and fury” comments from yesterday. With hindsight, mounting tension between the US and North Korea will have caused the decline, just like the assassination of Archduke Franz Ferdinand caused the First World War. Historians like nothing more than to attribute supersized actions to a single, seemingly obvious event.
As a researcher of confidence-driven behavior, I find this kind of attribution laughable. Events in and of themselves don’t cause anything. It’s our reactions to events that really matter; and there, our level of confidence plays a critical role. A confident child striking out at bat, for example, shakes off the misfortune, while a child lacking confidence is devastated. Mood matters. Our level of confidence determines our perception of events and drives our reaction.
For the past several months I have been watching the stock market’s reaction to the mounting missile crisis in North Korea, particularly the South Korean market.
As the chart above shows, despite accelerating North Korean missile launches, the KOSPI – South Korea’s equivalent of the S&P 500 – has shaken off the crisis. Rather than reacting fearfully, highly confident investors have been buying stocks at higher and higher prices in the face of a growing number of missile launches.
That the KOSPI and other major global markets have now, seemingly-suddenly, sold off on the news suggests that confidence may have peaked. Rather than shaking things off as they once were, investors now appear to be concerned. Even more, scrutiny, as it always does, is now intensifying along with the mood decline, too.
If confidence has peaked, the potential for a vicious cycle of mounting fear and falling market prices is high, especially given how richly valued equity markets are today. Overconfidence could quickly and quite easily turn to panic.
Over the coming weeks, I would pay close attention not to the specific events but to how investors react to those events. Growing fearfulness suggests lower prices ahead – at least until we see some kind of crescendo’ing capitulation. One the other hand, if we start to see investors shaking things off, the prospect for higher market prices and higher confidence ahead looms large.
Contrary to what historians suggest, events don’t make history. Crowds’ reactions do.
This is a Hedgeye Guest Contributor note written by Peter Atwater, founder and president of Financial Insyghts. He previously ran JPMorgan’s asset-backed securities business. He is also the author of the book Moods and Markets (FT Press, 2012) which details how investors can improve returns by using non-market indicators of confidence. This piece does not necessarily reflect the opinion of Hedgeye.