Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [10]
“The fundamentals of the economy remain strong.” That cliché is repeated by authorities as they try to restore public confidence after every major stock market decline. They have the opportunity to say this because just about every major stock market decline appears inexplicable if one looks only at the factors that logically ought to influence stock markets. It is practically always the stock market that has changed; indeed, the fundamentals haven’t.
How do we know that these changes could not be generated by fundamentals? If prices reflect fundamentals, they do so because those fundamentals are useful in forecasting future stock payoffs. In theory, the stock prices are the predictors of the discounted value of those future income streams, in the form of future dividends or future earnings. But stock prices are much too variable. They are even much more variable than those discounted streams of dividends (or earnings) that they are trying to predict.5
BERSERK WEATHER FORECASTERS
To pretend that stock prices reflect people’s use of information about those future payoffs is like hiring a weather forecaster who has gone berserk. He lives in a town where temperatures are fairly stable, but he predicts that one day they will be 150° and on another they will be -100°. Even if the forecaster has the mean of those temperatures right, and even if his exaggerated estimates are at least accurate in calling the relatively hot days and the relatively cold days, he should still be fired.
He would make more accurate forecasts on average if he did not predict that there would be any variation in temperature at all. For the same reason, one should reject the notion that stock prices reflect predictions, based on economic fundamentals, about future earnings. Why? Because the prices are much too variable.
Even this fact, blatant as it is, has not convinced efficient-markets advocates that their theory is wrong. They point out that the movements in stock prices could still be rational. They say that such movements could be reflecting new information about some possible major event affecting fundamentals that by chance did not happen in the past century, or the century before that either. In this view the stock market is still the best predictor of those future payoffs. Its gyrations are occurring because something might have happened to fundamentals. They maintain that the mere fact that the major event did not happen cannot be taken to mean that the market was irrational. Maybe they are right. One cannot decisively prove that the stock market has been irrational. But in all of this debate no one has offered any real evidence to think that the volatility is rational.6
The price changes appear instead to be correlated with social changes of various kinds. Andrei Shleifer and Sendhil Mullainathan have observed the changes in Merrill Lynch advertisements. Prior to the stock market bubble, in the early 1990s, Merrill Lynch was running advertisements showing a grandfather fishing with his grandson. The ad was captioned: “Maybe you should plan to grow rich slowly.” By the time the market had peaked around 2000, when investors were obviously very pleased with recent results, Merrill’s ads had changed dramatically. In one of these was a picture of a computer chip shaped like a bull. The caption read: “Be Wired . . . Be Bullish.” After the subsequent market correction, Merrill went back to the grandfather and the grandson. They were again patiently fishing. The caption advertised “Income for a lifetime.”7 Of course, the marketing professionals who concoct such ads believe they are closely tracking public thinking as it changes dramatically over time. Why should we regard their professional opinion as less worth listening to than the professional opinion of finance professors and efficient-markets advocates?
THE BEAUTY CONTEST AND DELICIOUS APPLE METAPHORS
In his 1936 book Keynes compared the equilibrium in the stock market to that of a popular newspaper competition of his time. Competitors were asked to pick the six prettiest