Trump, Sentiment and the Efficient Market Hypothesis

• Posted by Greg Harmon
• on November 9th, 2016

Stock markets Tuesday continued the move higher that they had started Monday. They closed within a couple of percentage points of all time highs at the end of the day. The election volatility seemed to have all played out. But the world now is a 24/7 place for news and we have Futures markets to reflect the financial views of that news. So when election results started coming in and Hillary Clinton was not going to win in a landslide, futures started to sell off. Later as Donald Trump won key states they slid further. And as it appeared that Trump would win S&P 500 futures were down over 100 points. How can this happen? I do not mean how can Donald Trump win or how can pollsters be so far off. But how can markets move so fast so quickly?

Earlier that day I had taught two classes. In the first I was starting to explain Technical Analysis to my Graduate School students. They are on a risk management track and I work Technical Analysis into the mix as a tool to help with that. The first part of our discussion centered around understanding the battle between supply and demand for stocks, or as Technical Analysts call it support and resistance. I followed this quickly with a discussion on sentiment and human behavior. And in here lies part of the answer to my question.

The second class was an Introduction to Corporate Finance class for undergrads, and it happened that as part of stock valuation I was speaking last night about the Efficient Market Hypothesis. My take there is that it is a fallacy, but you already knew that. But how fitting that these two subjects came up the night that information flow moved a market limit down and then saw it reverse sharply.

Markets are not efficient. You can see from this short term chart of the S&P 500 futures market the sharp steep sell off. Volume looks really heavy as well. The push back higher was not quite as sharp but was fast and also on strong volume. By the time most of America had woken up the S&P 500 had recovered over 50% of the move down. And as I write this futures continue to move higher. How can so much change occur in so little time?

Sentiment and the Efficient Market Hypothesis can explain a lot of it. Shifts in sentiment can be very powerful. Some show up quickly, like after an earnings event or a poll outside of our expectations. They are always very emotional. Out human brains are designed for protection and almost always ask us to do the wrong thing in markets when this protectionist reaction is triggered. How many of you sold all your stocks at the bottom in February 2009? For the advisers out there, how many times do clients get the most nervous and ramp up calls near the bottom of a market pullback?

But then cooler heads prevail and real market moving information starts to creep back into our brains. Earnings reports have been good and earnings forecasts are trending higher. Inflation may be creeping up but it is still controlled and the FOMC is already talking about raising rates. The lone factor then is how a Trump presidency will impact the markets. If anyone thinks they can tell you that today, this week or this month then you should stop listening to them. There are way too many moving parts. So expect markets to hold volatility measures a bit higher with that uncertainty. But beyond that inputs to market prices continue to look strong. Understand sentiment and react with facts.

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