Kevin Armstrong: Markets' behaviour is impossible to call

Investing is not an exact science, there are no absolute or perfect answers or explanations.

A recent Financial Times article by behavioural economics professor Paul de Grauwe neatly illustrated the shortcomings of traditional economic thinking when applied to currency markets. His comments, and particularly the illustration he employed, are instructive in understanding and appreciating the movements of any investment market from a behavioural perspective.

Behavioural finance and behavioural economics is a growing field of research among academics and active investors as the pure rationality of markets is brought increasingly into question. At its core, behavioural economics explores what happens in markets when participants display human limitations and complications and, in so doing, behave in ways other than that forecast by standard economic modelling.

One of the areas where this behaviour is most apparent in individuals is their limited ability to build complex and complete models of the world on which to base behaviour. Participants build relatively simple rules that they adhere to, at least while that rule or model works. The value of whatever rule is being employed is constantly being assessed and may be superseded if another better simple explanation starts to work better.

De Grauwe's primary interest is in currency movements. In published research, he has been highly critical of the reliance in exchange-rate modelling on the "rational expectations efficient market paradigm". This argues that an exchange rate can only change if there is news on the underlying fundamentals, similar to the now deeply questioned "efficient market hypothesis" in sharemarkets.

Exchange rates are far too volatile and deviate far too far from expected value for this to be a reasonable assumption. Additionally, the professor goes on to describe it as "extraordinary" and "unreasonable" to "assume that an individual brain is large enough and complex enough to master the full complexity of the outside world". If the model worked perhaps these assumptions would be reasonable, but the lengthy history of vast deviations clearly undermine such a view. As mentioned above, given our own inability to perfectly process the hugely complex world, we cling to something that appears to make sense and works for a while.

This behaviour was illustrated by De Grauwe in the Financial Times article. He described an experiment at a Belgian food fair. On the first day, boxes of Belgian chocolates were on sale for €9 and sales were satisfactory. On the second day, the price was increased to €15 and traditional economic thinking would conclude that sales should plunge, however they more than doubled. On the third day, the price was slashed to €2 and demand collapsed.

Just as it's difficult to calculate what the correct price for a currency is at any time, it is hard for consumers to know the right price for chocolates. In the absence of any other clues then, consumers only have the price to tell them anything about the chocolates. It seems that consumers in this experiment assumed that a high price implied high quality and, similarly, a low price implied poor quality. The apparent attractiveness of the chocolates was driven by the only information available.

A similar pattern has been seen in currency markets. At the beginning of 2005, the US dollar had been falling for more than three years and it was broadly accepted this trend should continue. The reason generally given was the United States' huge current account deficit. This became the crutch upon which market participants relied.

What actually happened was that the US dollar strengthened against most currencies, even though the current account deficit did nothing but get worse. Just as with chocolates in Belgium, the only thing market participants had to go on was price. A new explanation or rationalisation was sought.

In the second half of last year, the crutch for the US dollar's strength became interest rates and the current account deficit apparently became a far less important element in its value. Interest rates and the current account deficits undoubtedly play a part in the complex world of currency pricing, and they may have been the reason markets moved the way they did last year, but it is more likely they merely became the simple explanation for what was happening.

It has been interesting to watch what has been happening to the kiwi dollar. A year ago, it was expected to fall but it didn't. Towards the end of the year, a seemingly sensible view as to why the kiwi would stay stretched emerged and that was the vast issuance of foreign retail bonds: the so-called uridashis and euro kiwis. This issuance has continued but now the kiwi is falling and looks set to fall further with explanations for this ranging from the still stretched valuations, interest rates that will start falling later this year, maturities of previously issued foreign retail bonds and the growing current account deficit.

To paraphrase De Grauwe, the honest story of why currencies move is we do not know, but we don't like to admit this as our psyches abhor ignorance. That's why analysts' services continue to be demanded - they fulfil a psychological need to understand. No matter how much we think we may understand what is happening in any market it is likely that all we've done is arrived at an explanation, but probably nothing like the real story.

Successful investing is far from an exact science, there are no absolute truths, and success and victories are only ever fleeting. Investing is an art.

* Kevin Armstrong is chief investment officer of ANZ National Bank.