• Trading dynamics in Asian equity markets are increasingly more level-headed and less emotional, but volatility will not go away.
• Stock sell-offs in volatile markets create re-rating opportunities if a company is able to consistently deliver dividends and earnings growth to form a rising value formation path - when stock pricing gropes back to a more marketefficient state determined by this path, contrarian investing will be rewarded.
• A more rational market may mean re-rating gains can materialise with more certainty and speed for the contrarian investor.

Greed and fear have long influenced investors, driving sporadic bouts of sharp market volatility. However, the relative importance of such 'animal spirits' on volatility may be on the wane in Asia given the rising strength of other factors that could impact it.

One such factor concerns the maturing wealth management landscape. Asia's first generation typically made their wealth on the back of strong entrepreneurial energy and a willingness to take risks. Such attributes often find their way into stock markets, driving speculative bouts. As wealth passes to the next generation, the focus starts to shift to capital preservation, which may usher in a more level-headed approach. At the same time, an increasing openness to entrust money management to professionals is also evolving, which will help push a retreat on the emotions that lie deep in the retail investor psyche.

On the regulatory front, the crisis experiences of the past 20 years have taught policymakers to be more vigilant to speculative activity, especially those that could create negative feedback loops in the economy. China, for example, started to clamp down on shadow margin financing after a speculative market rally in the first half of 2015. Following a dangerous growth slowdown from 2009- 2013, its economic policy attention has also shifted to maintaining stability rather than the pace of growth - thereby setting an important tone on level-headedness for the local authorities and stateowned enterprises.

This new mindset will help to contain the influence of greed and fear. It is perhaps why the MSCI AC Asia Pac ex Japan Index (MXAPJ) still managed to chalk a steady advance in the past year despite Asia's share of negative headlines, which include concerns around China's debt to GDP ratio, the security dangers relating to North Korea and the protectionist rhetoric of Donald Trump. Clearly, better growth sustainability, improving corporate profitability and attractive valuations in Asia had not gone unnoticed.

This is far from saying that market volatility will go away. In fact, I believe volatility will remain an unshakable feature of stock markets even without the influence of emotion, simply because there are other aspects of our human nature that are also relevant.

A simple fact about human cognitive ability, that may take us a little humility to acknowledge, is that our rationality can only be applied within the scope of our interpretation of the world around us. The renowned Swiss psychologist Jean Piaget has much to offer in the understanding of our cognitive state when he described learning as a continual process of achieving equilibrium in our state of 'knowing'. When we encounter new stimuli, such as a new piece of market information or event, we first try to apply our existing 'schema' to comprehend it - our schema being essentially the inner framework which we use to perceive the world. Each of our respective schemas is shaped by our own past experiences and current circumstances. For example, those who had bad experiences in the 2008-09 Global Financial Crisis (GFC) may be more concerned that the rising debt to GDP levels in China will herald another financial crisis. But one could also see rising debt levels in China as a reflection that capital providers are better able to channel their funds to those who can make good returns out of them - that is, what one might expect from an increasingly efficient financial economy. In effect, differences in schema will drive different investment views even if the same facts are available to all market participants each trying their best to act as rationally as they can. Indeed, in the environment of the last 3-5 years in Asia, every market sell-off has had its own rationality built around it. The considerations that prompted sell-offs by some which ended up as opportunities for others may stem from differences in schemas, and not necessarily the logic around them.

The great economist Leon Walras, best known for his work on general equilibrium theory, described the market as "like a lake agitated by the wind, where the water is incessantly seeking its level without ever reaching it". This description is apt for equity markets when both buyers and sellers acting in their 'confined rationality' start to create price volatility that has the effect of groping towards a more efficient market state. In this type of volatility, the more pertinent question is not whether stocks have been oversold on emotional excess, but rather whether the market is acting on a rationality that is illconfined, or using outdated schemas that may soon be overturned.

To out-think and out-manoeuvre the market, we must therefore build schemas that are broader and deeper. It is not necessarily about trying to think out-of-the box, but more about expanding the size of the box by getting rid of the biases that colour our perceptions and limit the application of our rationality. We can also add new dimensions to our analysis, such as cutting the investment case along multiple time horizons. This has to be done deliberately as an ongoing exercise in schema strengthening, and to bring the approach to bear on ongoing investment performance means it has to be weaved into the investment process. For example, the process that we use for the Threadneedle Asia Contrarian Equity (ACE) strategy incorporates a well-organised top-down framework that has been tracking Asia's big picture themes over more than a decade, enabling us to run with the 'winds of change' that impact the region. Such a thematic framework required years of nurturing to give it breadth and depth, so that we can be quick and comprehensive in our assessment of the dynamic changes happening around us.

I have written previously about the emergence of 'great moderation' dynamics in Asia ushering in a period of lower volatility in our economic environment. Combined with the nature of equity volatility postulated above, it is therefore not a surprise to me that we have seen a gradual decline in volatility in the past year.

Figure 1: MSCI AC Asia Pacific ex JP - Annualised Volatility (EWMA)

Source: MSCI World Index 2017 

Does a lower volatility environment mean that our ACE strategy will not work as well, given that we seek to exploit the re-rating opportunities that arise from stock sell-offs? We believe the answer is "no" - in fact, we think the ACE strategy may work better.

Firstly, we anchor the medium- to long-term performance of the ACE portfolio on the value formation path coming from the dividends and growth/value creation of its investee companies. Dividends and growth are two of the three sources of returns that we can extract from equity markets, as outlined in the diagram below. A less volatile environment means stock prices will more accurately track this path, helping to ensure that we get rewarded in the shorter term as well as the longer term.

Figure 2: Asia's three sources of equity returns

Source: Columbia Threadneedle Investments, as at 31 March 2017.

Secondly, our contrarian approach seeks to exploit re-rating gains when they emerge from stocks that had fallen in the midst of price volatility. For stock prices to grope back to fairer levels, we still need a rational environment to facilitate the assimilation of positive aspects of an investment case. While lower volatility may shrink such opportunities, our win rate and waiting time will improve with rationality as stock prices are restored with greater speed and certainty to the levels that we deem justifiable, thus ensuring that the rewards of re-rating materialise timely.

In a nutshell, market volatility presents buying opportunities while rationality facilitates re-rating rewards over time. But success in seizing both depends critically on building a process that leads to schemas that are deep and broad enough to generate strong independent convictions that feed independent action. In a dynamic environment, the construction of schemas should be an ongoing process; and the way we go about it needs to incorporate a discipline of deliberate updates as it is crucial that our key beliefs are not easily shaken by current headlines.

Greed and fear have long influenced investors, driving sporadic bouts of sharp market volatility. However, trading dynamics in Asian equity markets are increasingly more level-headed and less emotional. A more rational market may mean re-rating gains can materialise with more certainty and speed for the contrarian investor.

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