Yves here. The headline overstates the conclusions from new research on the stock markets. However, the study serves to confirm that economists’ need to depict consumers and investors as cool and rational is all wet. But the assumption of strong-form rationality was essential to toy models that showed markets as producing virtuous outcomes. And do not forget, the need to shore up the pretense that market-based activity is at least efficient and better yet optimal (in terms of resource allocation) has become fundamental to the defense of capitalism. In other words, consumer/investor rationality is central to the economic dogma that defends capitalism.
We’ll get to the argument in the new INET paper soon, but basically, its authors are chuffed to establish that stock market activity is driven by stories. That is old hat to anyone on Wall Street. It is also old hat that decision-making revolves around stories; criminal attorneys know well that their success depends on getting the jury to put together the evidence and legal interpretations into a story they find convincing as the basis for their decision.
But back to the importance of the fiction of rational decision-making to economic dogma. For more detail, read ECONNED. Some key parts:
The scientific pretenses of economics got a considerable boost in 1953, with the publication of what is arguably the most influential work in the economics literature, a paper by Kenneth Arrow and Gérard Debreu (both later Nobel Prize winners), the so-called Arrow-Debreu theorem. Many see this proof as confirmation of Adam Smith’s invisible hand. It demonstrates what Walras sought through his successive auction process of tâtonnement, that there is a set of prices at which all goods can be bought and sold at a particular point in time.42 Recall that the shorthand for this outcome is that “markets clear,” or that there is a “market clearing price,” leaving no buyers with unfilled orders or vendors with unsold goods.
However, the conditions of the Arrow-Debreu theorem are highly restrictive. For instance, Arrow and Debreu assume perfectly competitive markets (all buyers and sellers have perfect information, no buyer or seller is big enough to influence prices), and separate markets for different locations (butter in Chicago is a different market than butter in Sydney). So far, this isn’t all that unusual a set of requirements in econ-land.
But then we get to the doozies. The authors further assume forward markets (meaning you can not only buy butter now, but contract to buy or sell butter in Singapore for two and a half years from now) for every commodity and every contingent market for every time period in all places, meaning till the end of time! In other words, you could hedge anything, such as the odds you will be ten minutes late to your 4:00 P.M.meeting three weeks from Tuesday. And everyone has perfect foreknowledge of all future periods.
In other words, you know everything your unborn descendants six generations from now will be up to.
In other words, the model bears perilous little resemblance to any world of commerce we will ever see. What follows from Arrow-Debreu is absolutely nothing: Arrow-Debreu leaves you just as in the dark about whether markets clear in real life as you were before reading Arrow-Debreu.
And remember, this paper is celebrated as one of the crowning achievements of economics.
And the notion that financial markets worked the way financial economics said was also exposed early on as bunk, but the theoreticians preferred to keep selling it than admit they didn’t have much to offer. Elite mathematician Beniot Mandelbrot got his hands on what was then the largest set of trading data and found that the distribution was not “normal” (aka Gaussian or “bell curve”). Their randomness was much wilder. He found that trading data from other markets showed the same behavior.
Here’s what happened next:
Mandelbrot and his ideas began to circulate in the financial economics community. At first, the reception was positive. The European polymath became an informal thesis advisor to University of Chicago economist Eugene Fama, who had found that the prices of the members of the Dow Jones Industrial Average were indeed not “normal” but were what statisticians called “leptokurtic,” with high peaks, meaning they had more observations close to the mean than in a normal distribution, but also much fatter tails. In lay terms, that means dayto- day variability is low, but when unusual events occur, variability both is more extreme and occurs more often than would occur with a normal distribution. MIT’s Paul Samuelson and other economists started looking into Lévy distributions and their implications.
The problem with Mandelbrot’s work, however, was it threatened the entire edifice of not simply financial economics, but also the broader efforts to use formulas to describe economic phenomena. Lévy distributions didn’t merely have difficult math; that might have been an intriguing challenge. There wasn’t even a way to calculate Lévy’s “alpha” reliably, although Fama’s efforts with market data did show that it was less than two, which confirmed the fear that the distributions were not normal.
The backlash was predictable. MIT professor Paul Cootner, who later published a book of essays on the random-walk hypothesis, tore into Mandelbrot at a winter 1962 meeting of the Econometric Society:
Mandelbrot, like Winston Churchill before him, promises us not utopia but
blood, sweat, toil, and tears. If he is right, almost all of our statistical tools are
obsolete. . . . Almost without exception, past econometric work is meaningless.
Surely, before consigning centuries of work to the ash pile we should like to have some assurance that all our work is not truly useless. If we have permitted ourselves to be fooled this long into thinking the Gaussian assumption is valid, is it not possible that the [Lévy] revolution is similarly illusory? At any rate, it would seem desirable not only to have more precise and unambiguous evidence in favor of Mandelbrot’s hypothesis as it stands, but also to have some tests with greater power against alternatives that are less destructive of what we know.
But Churchill had been right. The British prime minister had advocated a
difficult, perilous, and ultimately successful course of action, yet Cootner perversely
invoked him to argue instead for a failed status quo. He wanted assurances that exploring new terrain would be successful, but that isn’t the way a paradigm shift works. Indeed, Lévy distributions might not provide a comprehensive solution, but the point is to move toward better approximations, particularly when the existing ones have serious shortcomings.
Now to the current post. Note it suggests at the end not being under-diversified…but the notion that sufficient diversification (whatever that is) is good comes out of the Capital Asset Pricing Model. As we also explained in ECONNED, CAPM suffers from fatal internal contradictions, as even its creator, Bill Sharpe, conceded. But he reversed himself, falling in with the widespread view that a bad model was better than none.
By Lynn Parramore, Senior Research Analyst at the Institute for New Economic Thinking. Originally published at the Institute for New Economic Thinking website
If watching the stock market is giving you that old sinking feeling, you’re not alone. Inquiring minds want to know if the funds they’ve so carefully invested in 401(k)s are going to be there for them down the road. Investors of all kinds are worried about wild swings and lingering perils.
Here’s the unnerving thing: No matter how much market enthusiasts hype the stock market’s “efficiency” and hail it for incorporating all possible information, you’re always in for a surprise. That’s because just like death and taxes, you can count on stuff you never saw coming to throw off even the most careful and detailed planning.
Sometimes these unforeseeable events are big ones with massive market consequences. The “black swans,” as they are called, come in the form of terrorist attacks, financial crashes, and yes, pandemics. If an alien delegation lands on the White House lawn, that’s a black swan. These events ask our brains to process a lot of new and complex information. Suddenly old assumptions become irrelevant. New worlds open up.
When we are trying to make sense of things we don’t understand and can’t be certain about, our brains naturally turn to stories. For a long time, scholars in many disciplines, like history, psychology, and anthropology, have understood that narratives are extremely important to people and all that concerns them. Economists, however, have been late to the party. That’s why practitioners like Nobel laureates George Akerlof and Robert Shiller sought to change this by creating a subfield known as “narrative economics” which takes stories seriously and recognizes that they are major drivers of the economy.
The Story-Driven Stock Market
In his new contribution to narrative economics, Georgia Southern University economist Nicholas Mangee delves into the link between stories and unrepeatable, unforeseen changes and how they impact the stock market. In his new book from the Institute for New Economic Thinking’s book series with Cambridge University Press, Mangee tracks evidence of narrative dynamics through millions of daily stock market news stories from the last two decades of data, presenting an analysis of nonrepetitive events and associated story elements and how they relate to stock market changes.
Mangee did graduate work under maverick economists Roman Frydman and Michael Goldberg, who helped him to see that 1) unforeseeable change is always happening in financial markets and 2) mechanical ways of thinking that dominated traditional economics were inadequate to understand it — namely the assumption that the future follows mechanically from the past.
He knew that radical uncertainty has to be taken seriously.
Mangee saw that when it comes to the stock market, uncertainty and ambiguity are at the very core, which is why investors are all about stories. His dissertation work on financial news analytics convinced him that the factors driving stock prices are always changing over time, and nobody really knows which of them will matter the most to investors.
In a recent discussion, Mangee gave an example of just-released jobs numbers: “They blasted past expectations, but is that really bullish? Or is it potentially bearish because it confirms for some people that the Fed will tighten and rates are going to come up by more than they expected? Even when you have news that is scheduled, like jobs numbers released by the BLS, it’s not clear how the market is going to interpret that. Context matters.”
The core question in Mangee’s work concerns the degree to which the story threads that investors rely on and perpetuate over time help them deal with unforeseeable change and the uncertainty it engenders.
As he explains in his book, black swans draw people to stories and produce emotional reactions. Our emotions then get mixed into the kind of thinking Mangee refers to as “cold calculation” as we try make sense of what’s going on. Our brains buzz with questions: How will people behave differently? How will companies do business? What government policies can we expect? How we will live during and after the event? Rational sentiment helps reasonably shape answers to these questions in terms of current information and the reality that change is unfolding in real-time.
Mangee points out that just a few weeks after the coronavirus took off, the stock market lost a giant chunk of its total value, erasing the gains of 2019 and bringing a decade-long bull market to a screeching halt. Stories also quickly came into play, fueled by comparisons to history, personal judgment and prior experience, and scary emotions like panic and anxiety. People opened their inboxes to media stories like, “Panicked Shoppers Empty Shelves as Coronavirus Anxiety Rises” (NYT), which reflected, and helped generate, the stories that they latched onto.
“Narratives are the currency of uncertainty,” Mangee writes, and key to how we view the world in uncertain, changing, times. With this insight in mind, he created a new model of stock market instability under situations where we can’t measure the odds of a certain outcome (what economists call “Knightian uncertainty” after influential economist Frank Knight). His “Novelty-Narrative Hypothesis” (NNH) offers a way to understand the stock market that standard economics has missed.
Stories for Survival
Stories emerge not only in response to the big black swans but also to smaller unforeseen events like supply chain snarls and corporate legal issues. Even a product recall or a bankruptcy can create enough uncertainty and ambiguity to spark stories. These “novel corporate events,” as Mangee calls them, can impact the bigger trends and vice versa, in a processes too complex for our brains to deal with. So investors turn to narratives as a survival tactic, a defense mechanism, and a tool for making a satisfying decision when faced with limited information and Knightian uncertainty. Stories fill in the gaps, and, as Mangee points out, turn our emotions into cognitive guideposts and anchors when we’re dealing with the meaningof novel events for future stock returns.
We’re continuously dealing with novel events. Mangee notes, for example, that two-thirds of events identified in news reports as important to corporate prospects and share prices are “unscheduled,” as are four-fifths of big events in the U.S. economy. Instability and uncertainty are everywhere. All the time. Every day.
Some stories are flexible. Others are more rigid. Some are based on pretty good information. Others are not. They reflect our prior beliefs about how things work, and they reflect our culture, societal norms, and the popular zeitgeist. Some economists, like Shiller, have looked at the negative side of stories and how they drive us to do illogical things. Shiller scrutinized “narrative epidemics” and how stories are connected to cognitive disorders and conspiracy thinking.
Mangee has a different take. He explains that unlike Shiller, he doesn’t treat stories as stuff outside the stock market emanating within a few people’s minds, but rather a fundamental part of what the stock market is all about. He emphasizes that it’s perfectly rational, normal, and actually necessary for people to engage with stories when there’s uncertainty and ambiguity. Just because emotion is involved doesn’t mean that the stories will steer us wrong, Mangee stresses.
As Mangee sees it, traditional economists have tended to misunderstand how humans make decisions, holding the view that emotion and cold calculation are necessarily at odds. But he (like scholars from many other disciplines) holds that both are both perfectly rational and necessarily interdependent.
Mangee points out that capitalism produces profit –- and loss — through unanticipated change. “You can have knowledge and be skillful and roughly right,” says Mangee, “but you cannot know what precisely right looks like ex ante.” He says that when looking at the stock market rollercoaster currently underway, we can think of each moment in time as a node of intersecting highways of narratives concerning events that are not routine. “So you have a stock market correction of 10%. What does it mean? The Novelty-Narrative Hypothesis says that we have to take seriously that each and every day events are happening that are not perfect replicas of the past. We’re still learning about what omicron did and didn’t do to the economy, for example. The past doesn’t predict the future in a mechanical way.”
Mangee’s work suggests that ordinary investors need to diversify much more than they’re already allowing. Just holding the broad stock market doesn’t cut it. “There are too many macro shocks, so you need to be represented in more asset classes than just the S&P 500,” he says. “You need high and low yield bonds; high-cap, mid-cap, low-cap value stocks; high-cap, mid-cap, low-cap growth stocks; international, and so on. The S&P500 is dominated by high-cap. That’s not enough diversification.” Mangee’s work reminds us of how volatile financial markets can be.
His work also makes it clear that when we hear anyone making economic and financial forecasts, we need to keep in mind the limitations of those forecasts. “The recognition of those limitations should almost outweigh what the modelers are saying in their predictions,” says Mangee. “We have to give up precision but we can allow for more nuanced relationships and, importantly, for the novelty of real-world change. People don’t like that tradeoff, scientifically. They don’t like the idea that they can’t apply an objective probability distribution to something before the fact.”
Lastly, Mangee’s emphasis on the importance of narratives steers us to scrutinize our own and those of our communities. “Reality for an individual can depend on contextualized meaning of the world around us,” says Mangee. “You interact with this meaning, and the reality you shape depends on your training, your experience, your culture, your generation, your family — it’s all related.” It might behoove us to remind ourselves, especially when we’re pointing the finger at someone and saying “Oh, look, that silly person over there is making an emotional decision,” that we all make decisions based on emotion, whether we admit it or not. And that’s not a bad thing – we couldn’t deal with the unforeseeable future otherwise.
Perhaps the best way to approach the future in the face of uncertainty is with a strong dose humility. And beware of under-diversification!
Free market thinkers are their own worst enemy.
Relying on price signals from the markets.
“Everything is getting better and better look at the stock market” the 1920’s believer in free markets
In the 1930s, they were wondering what had gone wrong with their free market beliefs and worked out what had happened.
What had inflated the stock market to such ridiculous levels in 1929?
1) Share buybacks
2) The use of bank credit for margin lending.
The US stock market is doing really well with share buybacks and margin lending driving prices ever higher.
A former US congressman has been looking at the data.
He is a bit worried, hardly surprising really.
Unfortunately, we never learnt a thing from past mistakes.
Free market thinkers have taken intellectual laxity to a whole new level.
Last sentence nails it.
Intellectual laxatives? /s
May be yet another sign of mere humans being overwhelmed by the volume and complexity of data, looking for anything solid.
Unfortunately, most of the Proletariat are not even in the stock market. What savings/investment they make is in a bank savings account. Those with a salary and a 401k are usually following some “financial advisers” recommendation. Succeeding in the stock market is as much luck as it is skill; and if your that “skilled” then you should quit your current job for a higher paying one in Finance.
Diversification is not easy. It requires a constant assessment of your current and future needs (and the good fortune of not getting hospitalized for an expensive ailment). To diversify requires substantial funds and the ability to weather financial storms–as a solo sailor.
I think something is missing? I see a link, but not the INET piece itself.
Version control problem. Fixed. Sorry.
Well, it’s not only the stock market that runs on stories *), it’s the economist’s careers, and much of “social sciences” (however hard they try to aspire to hard sciences, of which only one is really hard – maths. Which is not a science). And the story that humans are rational is very much liked by most humans, who like to think about themselves as rational, especially when explaining why their rational investing didn’t work.
Incidentally, there was another interesting paper on markets behaviour, which was showing how markets are influenced by money flows (large amounts of money moving in/out). Of course, it entirely ignored what influences the money inflows – it was a quantitative paper, after all, so it treated it as a statistical fluctuations.
*) Terry Pratchett, one of the people who understood this well, said (loosely) that the world runs on “narrativium“.
The way I saw it put in a textbook on financial securities 20 years ago was: grades are given first, then the tests are taken. That is, company executives make promises about what will happen (stock prices adjust accordingly), the next quarter reveals if the story was true (prices adjust accordingly), repeat…
And a lot of the time the tests are a farce. Make em easy, beat em and let the rally begin!
Accuracy in predicting the future has a poor history. One doubts that this will ever change.
I sense a slight contradiction here hidden behind word choices.
First we have the obviously incomplete world of “perfect knowledge and perfect markets”. To quote:
“Here’s the unnerving thing: No matter how much market enthusiasts hype the stock market’s “efficiency” and hail it for incorporating all possible information, you’re always in for a surprise. That’s because just like death and taxes, you can count on stuff you never saw coming to throw off even the most careful and detailed planning. “
Then we have a revised description using creating narratives based on new knowledge:
“The core question in Mangee’s work concerns the degree to which the story threads that investors rely on and perpetuate over time help them deal with unforeseeable change and the uncertainty it engenders.”
Note the words “all possible knowledge” and “unforeseeable”. Some people are better and faster than others at incorporating changing information into their models. Two examples, one on the left, one on the right. A gun-nut friend of mine correctly predicted that the decline in trust in the US would convince people to stock-up on guns. He was right and his investment in manufacturers of guns paid off handsomely. I also know people with apocalyptic views on climate change who were quicker in the absence of complete information to invest in green energy and they, also, did very well. On the other hand I know people who bailed on California real estate in the 1970s because they thought “The Big One” was imminent. A reasonable narrative. They were wrong.
So what we have is the older view that there is a market in objects which is based on perfect knowledge, and a newer view that we have a market in narratives- stories- and that can mean the best story both in the sense of “best narrative I think we have” and “most predictive narrative base on future events”.
And that is the heart of the modern contradiction; the “best narrative I think we have” and “most predictive narrative base on future events” are often not the same. If the Germans had either concentrated on destroying the British coastal radars and bombing the forward fighter bases like Biggin Hill Station or been able to delay the invasion of Russia by a year and take over the Middle Eastern oil supply, Churchill’s “Blood Sweat and Tears” might have been remembered as the ravings of a deluded fool, in other words it would be remembered as “Great narrative but he was wrong”.
The housing collapse of 2006-8 is another example. It obviously wasn’t “unforeseeable” because some people saw it coming. The story they were telling turned out to be true… in retrospect.
And let’s not forget that Mandelbrot, who was one of the truly great geniuses of the 20th Century, looked deeply at apparently random things like the shape of coasts and saw more deeply than others that these shapes were not really random at all. Thus we got Mandelbrot fractals and a new narrative that explains coastlines far better than the old narrative. Mandelbrot started out in both economics and geometry by gazing at inconvenient sets of facts that were not well-explained by the prevailing narratives, which was at the heart of his genius.
The narratives are to create volatility.
Volatility metrics and options….like trying to hit a number on the roulette wheel. That seems to be what alot of it is about and not any type of economic or biz fundamentals. Biz fundamentals would matter for something like the S&P 500 companies if competition was stiff.
Just took a peak at the stock market narrative today. Disney stock is rising.
I guess nothing says “Hey, let’s go to Disneyland” to the average family like essentials in the cost of living rising….
Progress is rational, imo. It’s good for it to be a combination of calculation and emotion. Over the long haul an index fund gains value. If you are diversified, it’s like predicting the quantum world by looking at probabilities. Which is like saying that you really can predict a general direction. Diversification is evolution’s mutual insurance policy. It seems to have worked. I’m not sure I agree with novelty being a common occurrence. Maybe a better word is similarity. Similar, but just different enough. Because evolution is a very conservative process. There are only a few choices at any given time. And I just honestly do think that the past does, in fact, serve to predict the future in a sorta mechanical way. Because the threads of the past carry into the future. We humans should not be so impatient. Quick time is definitely not sustainable money. I mean, the word “hubris” isn’t some accidental noun. Predicting quick profits might actually work 51% of the time. I’ve heard it said that a trader only has to be right 55% of the time to make a good living. The best thing about the stock market is that it is there. It’s a work in progress.
Side note: for anyone interested in this issue, I would highly recommend Mandelbrot’s book on the topic that Yves alludes to in the intro – https://www.alibris.com/The-Misbehavior-of-Markets-A-Fractal-View-of-Risk-Ruin-and-Reward-Benoit-B-Mandelbrot/book/28332555
Mandelbrot goes through reams of data to show mathematically what really should be common sense – the movement of a market is not like flipping a coin and today’s prices reflect previous trends (or the narrative).
Very informative and also easy to read despite being written by a mathematician.
The stock market is a growth function. As a whole it goes up–by design. The people in charge will not allow it to go down or stay stagnant for any lengthy period of time. All the rest is just noise and timing. It will continue to increase forever or it will go to zero permanently. And if the latter happens, we likely have a whole lot bigger problems than the collapse of the stock market.
Sigh. I’ve got a real problem. I sold everything in one of my IRAs two years ago, just as COVID was hitting. Makes perfect sense if you believe in the old saw that consumers are what drive the economy and the market—there was a worldwide lockdown. Many people weren’t able to work; others were laid off—this had to cause a crash in the market, right?
Well, I couldn’t have been more wrong. The market is up 50% since I sold everything. (Looking back, I should have only sold half as a form of hedge.) Now I don’t know how to get back into the market. I don’t want to buy back in only to see the market crash now for some reason. Then I’d lose even more. So I remain in paralysis, thinking the market is overpriced and wanting to get in when there’s another dip, but the market just keeps on going up.
I’ve come to the conclusion that what is driving the market up is income inequality. The rich have so much money that they keep buying stocks, and that keeps the price inflated even though those old “market fundamentals” indicate that everything is overpriced. It’s the same thing with real estate and bitcoin and NFTs.
And what good does the stock market actually do, anyway? If I buy Apple stock, that money doesn’t go to Apple—it goes to somebody else who is selling their stock. The seller gets my money and a broker gets a commission, but nothing has been created.
It’s going to take a while for the high flyers to dump the bags without raising the alarm….hence a much slower walk down than the inexplicable rise up.
Bill, you fell victim to the conventional wisdom that tells people to sell into a declining market and buy into an expanding market. This is totally backwards from what you need to do to really make money–buy low, sell high. See my comment above. The stock market always goes up in the long run, so unless you need cash right now, you should buy after a correction and sell after a run-up (or hold if you are in for the long term).
Thanks, aj. I sold because I expected the market to crash even further—like a 1929-style drop–but as it turned out, I sold at the bottom.
I don’t know how badly you are trying to get back in, but don’t look at the indexes that drive the narratives.
They are propped up by a handful of stocks.
Individually, at the moment, lots of stocks have fallen into correction territory.
Bill, if you are currently out of the market, I’d be careful about jumping in back now. The current narrative is that inflation is rising and the fed is going to raise interest rates which will likely cause a market correction or at least some bullishness. Personally, I’m riding it out until mid-summer to see if there is a sell-off and then try to buy in after that. (typically I buy in after the “sell in May and walk away” crowd sells off and then I hold. Of course, I am by no means a financial genius or any sort of licensed financial advisor, so do your own research and assess your own risk tolerance accordingly.
Don’t fight the Fed. I held quite a bit of cash back then figuring I could buy in later and Iost out as well. I do think that markets can be manipulated by the Fed. I suspect economic reality is a very small part of stock pricing. Do you think there is political will to address the current inflation? Dems want to get reelected. They know they need to support of Wall Street. So I could see an attack on 7% inflation with a couple very minimal, meaningless rate hikes. Meaning the market goes to the moon. And if they can bring the SALT tax deduction back in the BBB (It was the largest or close to the largest part) they can almost guarantee they will win. And much of the democratic electorate especially in the South is on SSI, VA disability, or works for the government so they are insulated from the economy with escalators for inflation and they have government funded health care. Those getting killed by inflation like retirees and red state workers are not the big part of the democratic base. So contrary to common sense and good judgement I suppose we have to join the artificially created Bull Market or starve. The big tell is in March when we see what the Fed will do. My bet is little or nothing.
Unfortunately, I think most people believe that the president can actually do something about inflation, and they’ve bought into the lie that inflation was caused by the stimulus money. All the reporting about inflation has given all sorts of companies license to raise prices.
But anyway, I think you’re right—this inflated market is the only game in town. I can keep my money in the bank and watch inflation eat it up or I can dive back in.
It does seem that every attempt to manipulate stock prices involves a story. Even if that story is driven home by large purchases, those purchases are part of a story. If the purchases were not part of a manipulation scheme, there is no sense in portraying it in story form.
This is hardly surprising as it seems we are equipped by evolution to learn through stories more so than anything else. Christians proselytize their own children through stories (I never understood telling the story of the Great Flood as a children’s story, but they do. U.S. schools proselytize children with stories about U.S. history that aren’t anything close to the truth. But those stories still dominate people’s thinking to this day.
Consider what we are taught about stock markets in schools. Today the average Joe things that’s why stock markets exist, rather than predominately being a secondary market for stocks and bonds and a drag on the economy as a whole (by extracting rents from non-productive processes).