Some thoughts on Markets and Trading (From Econversations 1/24)

Who cares what everybody else thinks?


When the mean kids in middle school said something bad about you, someone probably told you “Who cares what everyone else thinks?” If you whined “but everybody else is doing it” to your parents, they probably responded with some variation of “if everyone else jumped off a cliff, would you?” Old adages tell us not to worry about what other people think is cool. Not being a lemming is what’s really cool.


Succeeding in the stock market, on the other hand, or other markets that hold similar properties, is one of the many reminders we all receive over our adult life that reputation does matter. John Maynard Keynes once likened the strategy behind stock market investments to a beauty contest in which, if you voted for the winner, you could be entered into a sweepstakes to win a prize. If you want to win the prize then, you should vote for whoever you think everyone else will vote for. The only problem is everyone else is also voting for who they think everyone else will vote for, which means you have to predict what everyone else predicts everyone else will predict that everyone else is going to predict. Get it? If not, check out this video.



The beauty pageant analogy applies to products or assets, like stocks, whose value is driven by perception. If everyone thinks (that everyone thinks) a stock is bad, no one is going to buy it, which will cause the price (and therefore the value) to drop. If everyone thinks (that everyone thinks) a stock’s value is going to skyrocket they are going to bid for it and bid the price up and so then the value does go up. This type of behavior is closely related to ‘herd mentality,’ ‘irrational exuberance,’ ‘animal spirits,’ etc. and could cause excessive volatility where changes in market values could reflect changes in fickle beliefs rather than changes in underlying values. Other examples include banks and real estate markets.


Bubbles, Bubbles, Trading and Trouble


Personally, I’m enjoying the irony of likening the world of finance to the disruption of the lessons of your youth, so I’m going to stick with it. What remains true: Bubbles are pretty and then they pop. What does not remain true: you don’t want to be the kid frolicking among the bubbles reaching up a pointing finger to pop them. You want to be far, far away, and the pointing fingers usually come after the pop.


We had a lot of talk at this week’s Econversations about market volatility, a central issue of which is trading strategies, particularly with regards to two of the major strategy camps: fundamentalists and chartists. Fundamentalists believe, ultimately, that a stock’s value comes from its “fundamentals,” which investopedia describes as “corporate events such as actual or anticipated earnings reports, stock splits, reorganizations, or acquisitions.” Chartists on the other hand follow day-to-day market data and charts to detect patterns in the stock movement to try to predict where markets are headed and make investments accordingly. However, market volatility can have significance to both types of traders. Market movements can guide trading decisions of both chartists and fundamentalists; the difference is that chartist decisions are driven solely by any patterns in the movement itself, while fundamentalist decisions are based on their assessment of the movement’s cause relative to the actual movement.


Some fundamentalists subscribe to the Efficient Markets Hypothesis. Robert Shiller, a renowned economist and well known critic of the concept wrote that the Efficient Markets Hypothesis “asserts that prices ‘efficiently incorporate all public information’ about fundamentals, fundamentals being economic variables that ought by rational calculation to affect securities prices. If prices reflect such genuine information, then the increased volatility we’ve seen is for good reason, a lot of important information flowing into the market, and ought not to be tampered with.” For a trader who believes in the efficient market hypothesis, any exercise in picking specific stocks would be futile unless they believe they have some relevant information that the market more generally does not (as yet). Therefore, those traders will instead make broader selections, balancing their portfolio with things like a broad index fund and low-risk long term assets such as government bonds.”

So, while neither type of trade is expressly disassociated from trading in volatile markets, follow up research does suggest that the contention that Chartists cause volatility is a fairly commonplace belief. Two researchers from the National Sun Yat-sen University in Taiwan wrote, “Fundamentalist behavior is assumed to have a stabilizing effect on market prices, whereas chartists tend to have a destabilizing effect and drive market prices away from the intrinsic value of the asset.” The study, which used Heterogeneous Agent Modeling to assess the relationship between Chartist behavior and market instability, also found that “volatility clustering,” “excess volatility,” and “financial bubbles” are all strongly positively associated with Chartist weights in the model.

So, the connection is clear, but the causal argument could easily go in the opposite direction: stock volatility increases chartist trading activity because stock movement is the basis of their trading decisions; market volatility might draw new traders to chartist behavior who are finding that the market is moving more than the fundamentals predict, etc. People make money on stock volatility and people lose money on stock volatility, what exactly we’re supposed to do about volatility has been a source of debate for decades (as have the causes of volatility).


Recommended Reading

(Hey, its not procrastinating if it’s productive.) (Right?)

Prosperity for All: How to Prevent a Financial Crisis

By Economist and Professor at UCLA Roger Farmer, the book criticizes both pre-Keynesian and New Keynesian theorists and instead encourages intervention in asset markets similar to the way that the central bank intervenes in money markets. While slightly longer than your average Cosmo how-to guide, managing an economy is one of the few things I’ll concede is more complex than managing my hair, and it looks like an excellent read if you’ve got the time.


House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again

Authors Atif Mian and Amir Sufi address the role of household debt not just in the Great Recession but in other historical economic crises and go on to recommend an overhaul of how we deal with debt, including a shift away from a system that focuses too much on supporting banks and creditors and a departure from “reliance on inflexible debt contracts.” I personally have no idea what such a departure would look like, and I’m very curious to see Mian and Sufi explain the possibilities.

After the Music Stopped: The Financial Crisis, The Response, and The Work Ahead

Touted by Shyam as the best book he’s read about the 2008 financial crisis, Alan Blinder’s New York Times Best Seller addresses, in addition to the housing bubble, the “implosion” of the “bond bubble.” Blinder also continues to move forward after assessing the causes of the crisis to assess the response, offering the equal parts optimistic and ominous assertion that thanks to successful government intervention “the worst did not happen.”