So GDP is down, retail sales have fallen off
a cliff, and unemployment is the worst it’s ever been, but the stock market… is doing
pretty good? What gives? Have all these traders been living in a cave
for the last three months? Or maybe they’re ahead of the curve, and
they already know that the economy is on the mend? That’s a nice thought, but it’s probably
safer to stick to Paul Krugman’s three rules about interpreting stock prices: “First,
the stock market is not the economy. Second, the stock market is not the economy. Third, the stock market is not the economy.” A lot of the rosy numbers are being driven
by big tech companies like Amazon and Apple, who are doing gangbusters with everyone trapped
at home. So-called “early cycle” stocks, which
tend to be more reflective of the real economy, like cars, banks and consumer goods, are lagging
behind. And thousands of small businesses crippled
by the pandemic are not represented in the stock market at all. Some economists describe what’s happening
as a market “de-coupling,” when stock prices cease to reflect economic realities. Most forecasters now predict a lot of bad
numbers in the coming months, yet investors are strangely optimistic. The warning lights are all flashing red, but
the market seems to be blissfully unaware of the storm on the horizon. If you’re thinking, “Wait a minute. I thought stock traders were supposed to be
really logical people,” ...well, you just waded into a century-long debate about the
very nature of the stock market. Is it a rational mechanism that accurately
reflects what companies are worth? Or is it governed by the touchy-feely emotions
and biases that all humans are subject to? There’s a long tradition of using emotional
phrases to describe the world of finance. The Great Depression. The Panic of 1837. Tulip Mania. Investors are often described as “optimistic”
and “cheery,” or “skittish” and “glum.” Alan Greenspan famously warned about traders’
“irrational exuberance” during the dot com bubble, and there’s an old Wall Street
saying that “financial markets are driven by two powerful emotions: greed and fear.” And yet, for much of the 20th century, the
consensus among economists was that the market was perfectly rational and stock prices were
always an accurate reflection of a company’s true value. According to the “efficient market hypothesis,”
investors react to good or bad news about a company, driving the price up or down until
the risk is balanced with the reward. Therefore, in theory, a company can never
be “undervalued” or “overvalued.” Since all public information about a company
is already reflected in its stock price, it’s impossible to “beat the market.” Many years earlier, John Maynard Keynes, one
of the godfathers of modern economics, doubted that a dispersed pool of investors could really
know a company’s true value. He compared the stock market to an offensively
outdated little contest the British newspapers would sometimes hold in the 1930s. They would print the photos of a hundred women
and ask readers to pick the six prettiest faces. The winner would be the person whose choices
most closely matched the average choices of all the contestants. The problem with this (aside from it being
an ancestor to Hot or Not) is that shrewd contestants would not pick the faces they
actually thought were the prettiest, or even the faces that they thought the average person
would find the prettiest, but the faces that they thought the average person would guess
the average person would find the prettiest. If you think your head is spinning now, consider
another version of this dilemma called the “2/3rds Game.” A bunch of contestants are asked to pick a
number between 1 and 100. The winning number is the one that is closest
to 2/3rds of the average of all the numbers. So if the average is 50, whoever picks 33
wins. But, assuming most of the contestants can
do basic math, they’ll probably choose 33, which means the winning number is now 22. And if most of the contestants anticipate
this, they’ll likely choose 22, making the winning number 15. And if they all guess that the others are
thinking the same way, they’ll choose 15 and the winning number is now 10. Depending on how clever the group is, the
winning number can quickly dwindle down to zero. These examples are meant to illustrate that
when people buy and sell stocks, they’re not always trying to predict something as
concrete as profitability. Many speculative traders are simply trying
to guess what other people will be willing to spend on a stock in the future, which is
dependent on what those people think other people will be willing to spend. Much like the 2/3rds game, this can cause
a cascading effect of over- or undervaluation. In the 1980s, the Nobel Prize-winning economist
Richard Thaler set out to prove that it was possible for companies to be over- or undervalued
by building two theoretical portfolios of stocks: “Winners” and “Losers.” The “Winners” portfolio was made up of
companies whose stock price had recently performed exceptionally well, and the “Losers” portfolio
was full of stocks that had recently performed exceptionally poorly. His theory was that these movements were fueled
by investors being over-enthusiastic about the winners and overly-pessimistic about the
losers. If he was right, then all these extreme prices
would regress back to the mean, causing the “Losers” portfolio to perform better. And that’s exactly what happened. In survey after survey, the Losers performed
better than the Winners, often by a wide margin. It seemed to suggest that stock prices can
be influenced by what Keynes called investors’ “animal spirits,” or what psychologists
might call “herd behavior”--jumping on and off bandwagons because everyone else is. What Thaler had tested was a form of “value
investing”--betting that certain companies are being undervalued by the market. The efficient market hypothesis said this
should be impossible, but tell that to Warren Buffet. And then, something happened that Thaler believed
settled the debate. Good evening. Today is Black Monday. The day the DOW dropped more than 500 points. Black Monday. On October 19th, 1987, stock prices crashed
all over the world, without warning or explanation. According to the efficient market hypothesis,
stock prices are only supposed to change based on new information, and yet there was little
to precipitate the crash other than that investors all got “uneasy” at the same time. How, wondered Thaler, could a stock’s price
be 25% lower than it was the day before and yet “both be rational measures of intrinsic
value, given the absence of news”? This is not to say that the stock market is
pure fantasy. Quarterly reports and profit margins do matter,
and you can’t have a high share price for long without something real to back it up. But the work of Thaler and other economists
did convince the financial community that there was some element of human irrationality
at play and it could be a cause of market volatility. So where does that leave us today? No one knows for sure why the stock market
is doing well during an economic crisis, but there are some theories. For one, the federal government has been pouring
billions of dollars into the economy--and that kind of sudden liquidity can be like
a shot of adrenaline, even if the underlying economy is weak. A second theory is that there’s nowhere
else for the money to go. Bonds currently have very low, even negative
returns, so investors have no choice but to focus on stocks. And with sports and casinos closed, even gamblers
are turning to the stock market as an alternate table to place their bets. And then there’s good old-fashioned FOMO. In a time of economic uncertainty, the stock
market seems to be the one thing that’s going well, so no one wants to be left behind. Whatever the cause of the de-coupling, many
experts warn that it probably won’t last forever. A new round of bad economic numbers, or the
Fed turning off the spigot might pull it back down to earth. Does that mean you should get out? Not necessarily. People who hop in and out of the stock market
tend to lose money compared to people who just sit tight and wait it out. Richard Thaler’s best piece of advice for
investors is to rarely check your portfolio and avoid reading the news. The stock market is not an oracle with all
the answers, nor a casino where anything goes. It’s a tool for growing your finances, and
like most tools, it’s safest to handle when you’re calm
and collected. And that's our two cents! Thanks to our patrons for keeping Two Cents financially healthy. Click the link in the description to become a Two Cents patron!
