Cuba and Trump - a quick study in market blindness

Cuba and Trump: a quick study in market blindness
Markets will always reflect better than they predict, even as they
attempt both
DECEMBER 9, 2016 by: Cardiff Garcia

For a quick study in market blindness, look at how an obscure US fund
reacts to events in a country where markets do not even exist.

Nearly two years ago US president Barack Obama and Cuban president Raúl
Castro jointly announced their intent to rejuvenate the diplomatic and
commercial relationship between their two countries. Until that day, the
Cuba closed-end fund had historically traded beneath its net asset value
by roughly 10-15 per cent. This Nasdaq-traded fund invests in American
companies whose shares are expected to benefit from cosier relations
between the US and Cuba.

A closed-end fund selling at a discount for prolonged stretches of time
is itself a mysterious phenomenon. But it is also common. What happened
next was decidedly uncommon. The day after the joint announcement, the
Cuba fund more than doubled in price despite no such move by the shares
of the companies it held. Eventually, it reached a price that was 70 per
cent higher than the aggregate value of its holdings. Only gradually did
some investors realise that their initial optimism about the
implications of the announcement for their fund was premature. Almost a
year passed before the fund had fully crossed its net asset value and
again traded at a discount.

The Cuba fund has experienced another two ephemeral spikes in price
since then: last February ahead of Mr Obama's historic visit to Cuba,
and two weeks ago after the death of Fidel Castro. In each case new
buyers might have believed that the specific event would lead to faster
improvements in economic fundamentals, but more likely they were just
participating in a typical Keynesian beauty contest, buying on the
expectation that others would buy.

No wonder that behavioural economist Dick Thaler often cites the fund as
an example of the efficient market hypothesis breaking down. Curiously
enough, several timely and relevant lessons can still be taken from the
fund's idiosyncratic recent history.

One lesson is that investors should be cautious about jumping into a
trade that is predicated on a political event turning out the way
markets expect. The most prominent example at the moment is obviously
the "Trump trade", premised on Donald Trump and Congressional
Republicans successfully agreeing a fiscal deal that includes
infrastructure spending, tax cuts, and financial deregulation.

Leaving aside Trump's erratic nature, US politics is about to enter a
period of densely intricate horse-trading whose results are entirely
undetermined. The simple truth — and the second lesson — is that markets
will always reflect better than they predict, even as they are always
attempting both.

Consider all that has happened in 2016. The frightening turbulence in
China that started the year subsided after the government injected
further stimulus. Brexit was not an immediate economic catastrophe. The
eurozone grew modestly but steadily, while the US and Japan shrugged off
a disappointing first half to record a strong third quarter. US wage
growth and price inflation finally started accelerating. Abysmal
recessions in Russia and Brazil seem to have bottomed. Oil and other
commodities rebounded. Leading indicators of global economic activity
are in fine health.

Despite plenty of extant risks, the avoidance of the doom scenarios
expected at the end of last year thus makes the reflation of markets
unsurprising in hindsight. They are merely keeping up with big
structural shifts.

It is important to keep the Trump trade in perspective. Gains in
equities, the US dollar, inflation expectations, and long yields may
have advanced in response to the US election, but all of them started as
early as mid-2016. Whether they have raced ahead of fundamentals simply
remains unclear for now.

Aside from endless Trump hysteria, next year also brings more threats to
the stability of Europe with elections in Germany and France, while the
fates of Italian banks and politics also remain foggy. Lesson number
three is that with omnipresent political risk entrenched in both
developing and advanced economies, more sharp swings will be impossible
to avoid.

Also worth mentioning is that each subsequent shortlived spike in the
Cuba fund's prices has peaked lower than the one before it, and each
correction quicker. Investors sometimes do learn from mistakes, as well
they should — a fourth and final lesson.

cardiff.garcia@ft.com

Source: Cuba and Trump: a quick study in market blindness -
https://www.ft.com/content/8ca08b6a-bd28-11e6-8b45-b8b81dd5d080