Markets (e.g. Herds of PEOPLE) aren’t very Rational a Lot of the Time

The Confidence Fairy is coming for your Savings!!!

One of the primary reasons I didn’t do an investments specialization for my PHD in financial economics is the overwhelming and pervasive group think on Rational Expectations or what’s called the Efficient Market Hypothesis. I’ve never really bought into this.  I think it is more an occasional circumstance or specific market behavior at that point when everything is going just dandy which is why I am more the sunspot equilibrium type.   I never found compelling reasons for the efficient markets view to be considered an overarching framework for all circumstances.  That kind of unorthodox outlook doesn’t buy you much print space in finance journals which means no tenure for you cupcake!!  (Although for some reason I can get it passed reviewers when it’s couched in the term “bubble” which is so very sunspot.)

Economists have become a little more accepting of the warts and  faults inherent in the hypothesis–notice it is still a hypothesis and not a theory–but finance people still have a tendency to worship at its alter.  Economists started out as philosopher social scientists–which is also why the big money is in finance–so they’re a little more open to the idea that markets aren’t all that efficient all the time.  I linked to the Wikipedia explanation of the idea for you which is adequate for our purposes.  The deal is when you build rational expectations into an economics model or investment model this is what you assume.

To assume rational expectations is to assume that agents‘ expectations may be individually wrong, but are correct on average. In other words, although the future is not fully predictable, agents’ expectations are assumed not to be systematically biased and use all relevant information in forming expectations of economic variables.

This basically rules out wrong group think that won’t deny “relevant information”.  If that was the case in reality, there would be no holocaust deniers, evolution deniers, climate change deniers, or flat earthers of substantial numbers to influence the average.  Basically, we’d have to accept the “average” rationality of today’s Republican Party and given the existence, electability and popularity  of Rick Santorum, Michelle Bachmann, and Ron Paul, I’ll rest my case and reject that. We have a major political party that’s basically a cult of irrationality these days.

There are two really important real life phenomenon that make that assumption look really bad in finance research.  One is a little paradox called the Home Bias Puzzle where research has basically shown that most people will still buy investments from their own country despite the availability of better deals abroad. The second is momentum.  This is the pack animal behavior in the market where you see something hit the market and suddenly every one is moving that direction when it doesn’t make much sense on a fundamentals level.  This is when I sell all my stock holdings.  The little voice inside of me will go:  “wtf is this rally for?  The economy isn’t all that great!  I think I better get out of here before they realize they’re all on something!”  This is how I’ve managed to remove my “ass”ets and avoid the major crashes since way back in the 1980s.

Whenever you get a financial crises or financial bubbles, you tend to get the panicked cow phenomenon in that if one is spooked the rest chase wildly along.  They’ve even programed this behavior into their computers oddly enough. Oh, and btw, none of the strategies and no market guru like Cramer or Buffet or Jesus your neighborhood grocer could ever be right and beat the market consistently if the financial markets were truly rational and efficient.  That’s another story, just accept my word for it right now.

I took an Advanced Investments Seminar because I had to for my final elective having no other choice and was subjected the entire semester to the work of Eugene Fama whose big fat head will be in Denver with me next month.   Fama is considered the father of modern finance and efficient markets is his dogma. He’s one of the jerks that was drinking the two overly expensive bottles of wine with Paul Ryan that BB wrote about awhile back. The other jerk being his son in law John Cochrane whose asset pricing models always assume the same efficient markets hypothesis.  The two of them have dominated finance for decades now and in my mind it’s held the entire field back and caused much damage in the real world. I had to recreate the research in many of Fama’s seminal papers and the most noticeable lunacy to me was how his data sets back then always skipped the Great Depression Era. His data sets usually involved equity market indices like the Dow Jones average during periods that excluded financial panics.  That never struck me as honest, but then, I’m not one of the Finance gods–there really are no goddesses–and so I don’t really get a say.

Again, I don’t want to teach this stuff so I generally avoid classes where the textbooks ooze it. I  inherited the sincerity gene from my father which causes me to go apostate on my students which may help their critical thinking skills but won’t further the ass-kissing group think skills required in today’s finance jobs. Also, I’m late to academic life and spent the 80s doing hedging, forecasting interest rates, pricing financial assets and liabilities, and generally surrounded by rational senior management thoughts  like:  “Gee, we’ll get bigger if we do this merger and I’ll get a bonus!  Who cares if it drags our income and balance sheet into the depths of hell?” I can also give you examples from the 90s too.  Irrational market decisions ooze from marketing divisions and departments daily.

So, behavioral finance and economics looks at the herd mentality that was originally identified as “animal spirits” by J.M. Keynes during the time period and stock market behavior that Eugene Fama likes to systematically ignore.  Keynes didn’t have the luxury of skipping over the data of the Great Depression. The kind of apostate philosophy that drives me actually has a label and basically looks at decision making under risky and generally unpredictable situations.  In a lot of cases, people don’t make decisions in these circumstances rationally.   BB and I have been having some phone conversations about the topic because as a psychologist, she’s very interested in human behavior.  Human behavior very much causes people to do different things under times of risk.  Let’s face it, people and hence markets aren’t very rational a lot of the time when they’re panicked about losing their jobs, their businesses, their homes, and their savings. They’re a lot more efficient, rational decision makers when circumstances are not risky and unpredictable or when the biggest decision variables are messy and not well understood. Then, there’s the existence of powerful “deciders” who think their egos have a better understanding of alchemy than their necromancers and are on the look out for narratives to reinforce their beliefs.  Remember the word narrative because it plays a big role here in where I’m going and where Robert J. Shiller went.

So, this background chat brings me to the topic of this blog post which is a project syndicate article by Robert J. Shiller who is a very well respected economist and dabbles in behavioral economics. He is well known for the Case-Shiller index which measures activity in the housing market in some key markets. (BTW, Case is a big sunspot equilibrium sort as is Douglas Diamond who the Republicans ran out of the District earlier this year.)  I’ve taught out of his textbooks.  He teaches at Yale and co-authored a book with Nobel Prize winning George “market for lemons” Akerlof called “Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.”.  His voice is important in this day and age of people chasing confidence fairies and reacting to events here and in Europe rather irrationally which frequently happens during periods of great uncertainty and increased risk.

I’m consistently amazed at the success of the narrative that Republicans have managed to push into the national psyche that we’re over taxed and that our national debt is horrendous as its never been before and that our children and grand children will be crushed by it.  You even hear President Obama spew the stuff and he should know better given his ability to access any of the aforementioned economists by phone easily.  As I’ve said before with the use of data and nifty graphs,  the debt was far worse after World War 2, the tax rates far higher and none of us or the US economy was the worse for it.  Really, would you have rather they not borrowed money to fight World War 2 and lived with those results instead? We had nothing but debt when started out as a country and also after the Civil War.  As long as you have lots of really high quality assets and people and the power to tax and print money, it’s NO BIG DEAL! Greece does not have Bill Gates and Microsoft continually pumping out huge amounts of value. We have him and lots more like them!  People have been reacting to ideological nonsense and narratives.  We have a failure of governance and policy because of this. That’s hardly rational.  It’s also causing bad effects in our home prices, the value of our savings, and our ability get and keep jobs.

So, here’s Shiller writing on “The Great Debt Scare” about how this ideological nonsense has shaken consumer confidence in both Europe and the U.S. causing a “perverse dynamic” that has been discouraging consumption and investment which has brought about economic weakness.  What this basically shows is that the psychology of self-fulfilling prophecies is alive and well in financial markets. Rational Markets my swamp people ass!

We now have a daily index for the US, the Gallup Economic Confidence Index, so we can pinpoint changes in confidence over time. The Gallup Index dropped sharply between the first week of July and the first week of August – the period when US political leaders worried everyone that they would be unable to raise the federal government’s debt ceiling and prevent the US from defaulting on August 2. The story played out in the news media every day. August 2 came and went, with no default, but, three days later, a Friday, Standard & Poor’s lowered its rating on long-term US debt from AAA to AA+. The following Monday, the S&P 500 dropped almost 7%.

Apparently, the specter of government deadlock causing a humiliating default suddenly made the US resemble the European countries that really are teetering on the brink. Europe’s story became America’s story.

There is something—most likely hard wired–in people that creates highly irrational narratives ( we call them frames) to justify stuff that occurs even in the face of incredible evidence against the frame. It’s why there are so many evolution and climate change deniers. The narrative makes them feel better than the reality.  We all edit out the data coming from those periods of intense irrationality–like Fama did with the Great Depression–to justify our pet juicy rationalizations.  It’s like the post-trauma narrative you create to justify something you did when your lizard brain kicked in. Republican and so called conservative operatives seem to thrive on spinning lizard brain activity into parable like narratives to hone their advantage.

Changes in public confidence are built upon such narratives, because the human mind is very receptive to them, particularly human-interest stories. The story of a possible US default is resonant in precisely this way, implicating as it does America’s sense of pride, fragile world dominance, and political upheavals.

Indeed, this is arguably a more captivating story than was the most intense moment of the financial crisis, in 2008, when Lehman Brothers collapsed. The drop in the Gallup Economic Confidence Index was sharper in July 2011 than it was in 2008, although the index has not yet fallen to a lower level than it reached then.

So, what do these current confidence surveys tell us according to Shiller?

The timing and substance of these consumer-survey results suggest that our fundamental outlook about the economy, at the level of the average person, is closely bound up with stories of excessive borrowing, loss of governmental and personal responsibility, and a sense that matters are beyond control. That kind of loss of confidence may well last for years.

That said, the economic outlook can never be fully analyzed with conventional statistical models, for it may hinge on something that such models do not include: our finding some way to replace one narrative – currently a tale of out-of-control debt – with a more inspiring story.

So after our lizard brain causes fight or flight, the Captain Picard part of our brain tells us to make our narratives so. What we are building into our psyche is not any kind of analysis based on rational views of historical data, economic theory, or for that matter, common sense.  What we are building into our psyche is a narrative that isn’t very rational and that’s impacting our behavior and the behavior of markets.  Now, if we could just stop the press from reinforcing all the irrational crap out and about these days maybe we could sit down, take a few deep breaths, and peel back the layers of skin on the onion of those destructive narratives.  Think about it. Yes, the Garden of Eden story is a great narrative, but what explains the carbon dating data on rocks, the dinosaur bones, and the vast existence of several varieties of protohumans’ remains better?  Dinosaurs and Neanderthals in the Garden of Eden with Adam and Eve (not Steve or Lilith) or the Big Bang THEORY and the THEORY of evolution?  What explains the financial crisis and the fallout better?  The narrative that it’s too much government debt, too high taxes, and too much  regulation that were all at much lower levels now than after the World War 2 economic boom or excessive speculation in the markets and exotic, difficult to price, unregulated derivatives, NINJA loans, government encouragement of monopoly and oligopoly power, and  fiscal policy known to suppress economic growth? Your choice.  Theory or comforting bed time tale.