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Please see the below article from EPIC Investment Partners detailing their thoughts on volatility referring to the Hare and the Tortoise fable.

Last week we discussed the low levels of volatility from a technical perspective. However, there is a related, fundamental question that has puzzled economists and investors alike for decades: “Is market volatility driven by animal spirits or is it rational?” In 1981, Nobel laureate Robert Shiller phrased the question as “Do stock prices move too much to be justified by subsequent movements in dividends?” 

The answer is key to understanding how markets work and whether we, as investors, can trust the prices we see. As Keynes warned: “Markets can stay irrational longer than you can stay solvent.” It is not only about risk, but also opportunity to profit from irrationality if one can time it right. Both behavioural psychology and fundamental analysis depend on markets that regularly deviate from rational pricing, and many investors have argued against the efficient-market hypothesis that prices reflect all available information. 

However, a recent study published by the National Bureau of Economic Research (NBER) suggests that the market may be smarter than we give it credit for. This study argues that stock price volatility can be largely explained by changes in investors’ expectations of future dividends. In other words, when stock prices jump around like a hare on a trampoline, this is not because the market has lost its mind but because investors are updating their beliefs about the company’s future cash flows. The fact that stock prices tend to move in line with changes in dividend expectations suggests that on average, we are pretty darn good at it. 

Such news would be disheartening, setting a high standard for any individual fund manager to outperform a relative index. Should we abandon all our hope and worry about irrational exuberance in the market? 

Well, looking at the crashes of the past as well as recent market movements, it is hard not to think of situations where stocks were either skyrocketing or nosediving based on hype rather than fundamentals. How to account for those? Either these prices are fairly based on genuine expectations, or there is an opportunity hiding at the other end of the spectrum: those sleepy tortoises that we do not think about that are just stuck in the slow lane while the rest of the market jumps around. It might be that, for each exciting jittery hare, there is what seems to be a tortoise in its shell, and no one has bothered to touch it despite a change in prospects.

So, the next time we are faced with the statement that the market is irrational, the appropriate response might just have to be a grating “it depends”. The hare and tortoise may just balance each other out. We should still recognise both for what they are and make investment decisions without prejudice. 

(Although, of course, Aesop’s fable teaches us that it is the tortoise that wins in the end.)

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Alex Clare