What To Do About Financial Noise

In 1965, two astronomers in Crawford Hill, New Jersey, were monitoring radio emissions from the Milky Way when an annoying hum interrupted their work. Was it coming from nesting pigeons who left droppings inside their antenna? In fact, the astronomers had been observing the cosmic background radiation of the universe.

In financial markets, too, low-level noise can be distracting. Sometimes it may prove to have viable information. Other times, the sounds are meaningless — like the pigeons.

Meaningless noise versus useful information

Noise is frequently distinguished from “information” that serves to identify a trend or fundamental value. Investors who watch the market closely overreact to ups and downs, but noise usually washes out, like water in a ripple tank where different waves move around to cancel each other out.

Consider the barrage of media pundits who speculate over possible Federal Reserve moves. They analyze securities, recommending that audience members buy, sell or hold. Although occasionally a very influential analyst may trigger a warranted shift in a stock price, most babble soon cancels itself out. A 24-hour news blitz of television and internet reports tempts markets to overact, such as on Friday afternoons when the market does not have quite enough time to interpret a particular item. Usually, nothing takes place, and the noise dies down by the following week.

Human nature leads us astray

Where is the market focusing its attention? In a beauty contest, one does not win by choosing the prettiest face, but rather by anticipating the average audience member’s choice. In other words, it is not sufficient to assign share prices based on fundamental values. You have to guess what others will perceive the share prices to be.

Intuition can lead traders astray, encouraging them to build illusory patterns that turn out to be red herrings. It is in people’s nature to look for meaning, so they are inclined to seize on patterns and put too much weight on them. Investors also tend to prefer precise forecasts over accurate information. It might be an exact prediction to announce that oil will rise to $150 a barrel, but what matters is whether it is true.

One investor’s noise is another investor’s information. For an endowment or pension plan on a 20-year investment cycle, some noise could theoretically last five years or so. In the most extreme case, equities tend to rise over the long term anyhow. In that case, everything else becomes noise except for the upward bias.

Those with a shorter outlook must identify how much information has already been discounted. Investors place undue weight on learning about new events, yet by the time they become aware of them, the occurrences have probably been computed into the prices. Surprise is what drives the market, rather than what has already been recognized.

The data follows the calendar

You need not respond to every bump in the road. Markets still react to gross domestic product reports, even though many become old news after two or more revisions. That is not to say that pieces of evidence should be ignored. The key is assembling the various factual elements.

You would not want to base long-term decisions on a sole measurement, such as monthly employment reports, durable goods or capacity utilization. The individual numbers are too unreliable and subject to revision. Taken in their entirety, they can still provide a pattern or trend.

Regular monthly data can be ranked in order of significance. Among the top-tier data are economic indicators released during the first week of each month, including the purchasing managers’ index, the consumer price index, unemployment numbers and auto sales. Factory orders and durable goods constitute the middle tier. Throughout the month, we get secondary surveys and confidence measures. Many studies confirm that those are lagging indicators, which do not correlate well with fundamentals. Nevertheless, they tend to propel markets temporarily.

Noise will make anxious investors start to question their commitment to their investment disciplines. Your financial adviser can help you revisit any specific issues methodically. Together, you can discuss why a particular position was purchased for the portfolio and why it should or should not remain in it.

Reach out to Roz Carothers and her team at Triplett & Carothers to learn more.