From early childhood, humans are immersed in stories and as a species we have learnt to use narratives to educate the young, influence our peers and in attempts (religious and scientific) to explain the origins of the universe. These constructs exert powerful behavioural influence, which has been used for good and for ill. After all, as Joseph Goebbels once said: “If you tell a lie often enough, eventually people will start to believe it.”
In 2017, the integrity of information consumed in the developed world is again under heavy scrutiny, with concerns that ‘fake news’ is partly to blame for fanning the fires of a new wave of populism; one that once more contains worrying elements of religious intolerance, racism and xenophobia. Like Goebbels in the 1930s, the modern-day pedlars of ‘alternative truths’ understand the power of narrative, as demonstrated by the battle on social media and news websites to shape the flow of opinion on controversial issues such as gender, immigration, globalisation and foreign policy.
The field of economics has, surprisingly for a social science, been slow to appreciate that adoption of narratives is crucial in recessions, booms and for the confidence of investors in the stock market. This scholarly deficiency has been identified by Nobel laureate Professor Robert Shiller, of Yale University, who made narrative economics the central theme of his 2017 presidential address to the American Economic Association (AEA).
Professor Shiller’s address expanded on themes explored in the book he wrote with Professor George A Akerlof, Phishing for Phools – The Economics of Manipulation & Deception (2015), reiterating the fundamental role communication plays in human society and endeavour. This, he opines, inevitably has a huge economic impact and one that has hitherto been neglected by academics, policymakers, consumers and investors.
The premise for Professors Akerlof and Shiller (or George and Bob as they informally refer to themselves in the book) is that decisions made by consumers, companies, governments and investors are not always made on the basis of optimal efficiency, ie to reach the outcome that yields maximum utility for the lowest possible expenditure. A central theme of their book is that emotional “monkeys on the back” drive actions of market participants; and the extent to which cognitive biases and weaknesses can be exploited, or “phished”, is crucial in coming to a market price equilibrium.
In the case of individual purchases, George and Bob’s broadened definition of phishing includes the tricks that a car salesman might employ to get you to add optional extras, and to sucker you into using their expensive vehicle servicing or finance packages that seem attractive but aren’t as good as you could get elsewhere. For whole financial markets, the collective phishing of participants creates an equilibrium where it is possible to over- or underperform stock indices by virtue of having been phished to a lesser or greater extent than others.
Narratives as the ‘dark matter’ of market mechanisms
According to the efficient market hypothesis (EMH), capital markets work to reach the true and fair value of securities. The unpredictable nature of information flows is responsible for prices behaving in ‘a random walk’ – moving erratically as news becomes available – but ultimately all securities reach their natural price equilibrium. Therefore, so the theory goes, while abnormal profits can be made speculating on the direction of prices, this is just luck and it should be impossible to consistently beat the market.
We often hear of surveys, like the one carried out by S&P Dow Jones Indices in 2016, that highlight that a majority of fund managers underperform their benchmark. Such empirical evidence seems to support EMH, but there are still weaknesses in the conventional notion of efficient markets. Behavioural finance experts point out that people have bounded rationality – due to constrained time and cognitive capacity, only a limited number of facts are used in decision making.
Even where complete information is available, therefore, much of it can be discarded or interpreted in a manner that leads to suboptimal decisions. This translates to anomalies in security prices, which can cause investors to make a profit or loss. The way that stock market participants are ‘phished for phools’, is in the narratives that they weld to their own cognitive biases when making choices that are not the most advantageous. This happens on such a scale and to so many people that market prices come to represent a phishing, rather than an efficient equilibrium. In effect, the narratives that exist in markets are like the dark matter in the universe – we find them elusive and, as yet, impossible to quantify – but we can be almost certain they exert enormous influence.
Factor returns as evidence in the case against efficient markets and for the importance of narratives
The weaknesses in the EMH assumptions, that investors use all the information available to them and behave totally rationally, are laid bare by the proven capacity of certain risk-return factors (also called ‘investing styles’) to outperform the stock market. For example, we know that over time momentum investing (the strategy of buying the best performing stocks of the previous period and holding them for the next period) has trounced many benchmark market indices around the world.
US-based academics Jegadeesh & Titman (1993) explain this phenomenon as due to most investors being Bayesian conservatives: they initially underestimate the probability of positive effects from good news about companies and only later pile in behind the first people to buy stocks on, for example, better-than-expected profits.
Similarly, the value factor – which has been much in evidence since the second half of 2016 – is explained by the majority of investors having underestimated the productive capacity of companies’ assets. As Professor Shiller pointed out in the paper that accompanies his AEA address, the value investing premium proves there has long been a reward for ‘smart-money’ investors using fundamentals to identify such opportunities and profit from a price rise as Johnny-come-lately ‘noise’ investors pile in.
Unfortunately, making outstanding investment returns is not simply a case of seeking out stocks that score highly on certain factor characteristics. Unless you have a very long time horizon and the discipline and resources to make many trades, there is a serious risk of being caught out by spells of severe underperformance, which factors, such as value and momentum, are renowned to suffer.
Booms, bubbles and busts – how narratives feed in to the stock market
Professor Shiller is perhaps most famous for his work on stock market valuations using the cyclically adjusted price/earnings ratio (CAPE). Unlike a traditional price/earnings ratio, CAPE takes the average of inflation-adjusted earnings over a period of time (most commonly 10 years) as the denominator in the ratio. This removes the impact of cyclical anomalies in earnings and gives a more useful measure with which to compare valuations over time. When the ratio has been high, subsequently lower stock market returns have been observed, which is ominous given that the current CAPE for the S&P 500 is around 28 - significantly above the long-run average of 17.
By Professor Shiller’s own admission, however, CAPE is not a good tool for market timing: the ratio doesn’t indicate that a crash is imminent or overdue, rather it is a sign that going forward the compound annual growth rate (CAGR) of the market will be lower. The CAPE for the S&P 500 has been high since 2013, but there has been no crash as the chief narrative in the stock market has been low interest rates and the rock bottom yield on traditionally safer assets such as government bonds making equities attractive. This is an entirely different scenario to the period leading up to the dotcom crash, when the yield on 10-year US treasuries was over 6 per cent.
In this scenario, the high CAPE multiple implied that investors expected a huge growth premium as the valuation of the whole index began to look like that of a growth tech stock. CAPE for the S&P 500 eventually peaked at an eye-watering 44 in December 1999 and on this occasion was portentous of a savage bear market.
Creeping dishonesty – how changing narratives make a nest for Black Swans
The collapse of Lehman Brothers lit the touchpaper for two months of stock market falls that should not even have been possible going by conventional statistical models. We have written in the past on some of the newer risk-modelling techniques that are more accurate than the Gaussian measures used by most banks and funds before the financial crisis. Even these, however, would not have accurately forecast the size of cumulative market falls experienced in September and October 2008 (although they would have got much closer). Such events are often referred to in statistics as ‘Black Swan’ events – totally unpredictable and with results that alter future statistical parameters.
The second part of the Black Swan definition undoubtedly applies to the autumn of 2008 – the magnitude of such events can never be forecast with 100 per cent accuracy (although with more robust methods and large enough data sets the approximations are getting better), but if we consider the financial crisis in the context of how narratives in investment banking changed over time, can it truly be said that some sort of reckoning was not foreseeable? OK, this line of argument is open to accusations of hindsight bias (if you like, grafting another narrative on to past events to fit a theory today), but there were many people who questioned banking practices long before 2007.
In Phishing for Phools, Bob and George note that even in the late 1970s John Whitehead, then a senior partner at Goldman Sachs, was concerned with the way investment banking was changing. The traditional business model for investment banks had been to act as a trusted counsel to their large corporate clients – offering sage advice on tax efficiency and circumventing regulators in return for getting the nod as lead underwriter on lucrative security issues. Part of the business was the syndication of issues with other banks, to pool distribution and marketing networks for floats and issues. While aiding and abetting tax avoidance and minimal compliance with regulations is hardly laudable, in the old days at least, prioritising the interests of clients was integral to banks’ business models. Furthermore, with trust central to the profit-driving activity of securities issues, it was in everybody’s interests to ensure the accuracy of credit ratings.
This ‘trusted friend’ business model, as Bob and George put it, began to hold less sway as banks started to make more of their money acting as custodians in the growing repurchase agreement ‘repo’ market. Investment banks are attractive overnight depositaries (for large corporations, retail banks and money market funds) as they offer the protection of securities as collateral for the clients’ cash. The expansion in repos handed banks a rich pool of liquidity with which to trade on their own books and generate new profits. The model depended on having good quality collateral to put up for cash deposits and, at a stroke, banks’ primary interests with regards to credit rating agencies shifted from the integrity of ratings being unimpeachable, to it being most advantageous to acquire the highest ratings possible for collateral stock.
At the end of the 1970s, these subtle changes prompted John Whitehead to propose a statement of principles reaffirming Goldman Sachs’ commitment to putting clients’ interests first. This was remarkably similar to the mission statement of the revamped UK regulator, the Financial Conduct Authority (FCA), in the aftermath of the financial crisis in 2010. As it turned out, Mr Whitehead was swimming against the tide, but he had identified changing narratives in investment banking relationships that posed a risk to the integrity of the industry.
We all know the results. By the mid-2000s, an ‘ask no questions’ culture had rotted the financial system to its core, with complex derivatives based on tranches of collateralised debt obligations (CDOs) being sold, repackaged and sold on again with woefully inadequate standards of due diligence. It all stemmed from a blind and all-too-convenient acceptance of credit ratings. Thanks to a phenomena Bob and George refer to as “reputation mining”, the good name of the rating agencies built up in the days of trust-based investment banking had been abused. Ratings were then taken at face value and warning signs of the systemic risk posed by a flaky pyramid of debt were wilfully ignored.
The role of narratives in recessions and stock market crashes
Keeping track of narratives could potentially help us stay alert to the possibility of financial crashes and, similarly, the narratives that take hold in times of crisis also affect the length and depth of recessions and bear markets. Professor Shiller believes that much of the impact policymakers have is rooted in the narratives they help create or perpetuate, rather than just the fundamental implications of decisions.
For example, allowing Lehman Brothers to fail sparked a panic that, on its own, came close to triggering systemic failure. The risk of allowing exposures in the credit default swap (CDS) market to pose the threat of annihilation to AIG, or of letting Fannie Mae and Freddie Mac collapse under the weight of bad mortgage loans on their books, was deemed too great and the US taxpayer came to the rescue. There are many who would argue that the focus of action should have been to protect individuals in the real economy and not reckless institutions. This is an argument that naturally appeals to a sense of fair play, but in a crisis that spread like wildfire the quickest way to stymie the panic and instill a different narrative (even if panic was replaced by indignation) – was to bail out the institutions at its heart, however unpalatable that might have been to ordinary taxpaying citizens.
Professor Shiller sees the narratives that were allowed to take hold as the main reason for the length and suffering of the Great Depression period (1929-41). President Roosevelt himself, in his fireside addresses over the wireless, sought to assure Americans that “the only thing they had to fear, was fear itself” and Professor Shiller argues that, before FDR’s messages of reassurance, the narrative of fear spread among the general populace prolonged the economic pain. Damage done by runs on banks was a major problem, as against this backdrop of panic it became near-impossible for normal functioning of the retail banking system to resume.
One of the features of the October 1929 crash that kick-started the depression was the high level of participation by private investors, who had even borrowed money to invest in the stock market. The feeling of impending doom felt by these people, spread into the wider economy and also helped precipitate those damaging bank runs. By contrast, following Black Monday in 1987, there was not the same degree of economic meltdown, perhaps because a higher proportion of market participants were institutional investors.
The end of the depression only came about with US entry into the second world war, which fundamentally changed the prevailing narrative in American society from one of fear, to patriotic fervour and onward resolve. There was also huge fiscal stimulus combined with anti-inflationary measures that would not have been possible to implement in peace time. Coupled with the fact that the war dragged America out of quarter of a century of isolationism, and paved the way for the US to make hugely advantageous economic agreements like Bretton Woods in 1944, the transformation from depression to a 1950s boom was assured.
Politically motivated narratives in 2017
Just last week, the Bank of England raised its forecast growth rate for the UK economy in 2017 to 2 per cent, completing quite the turnaround from the doom-mongering narrative that Governor Mark Carney was criticised for being party to ahead of last June’s referendum on Britain’s membership of the European Union. Mr Carney was also accused of overreacting to the Leave vote when he announced a renewed monetary stimulus package last summer, including record-low interest rates of just 25 basis points and a new quantitative easing (QE) programme (now completed) of £435bn in asset purchases.
The impact of the measures have been questioned, but Mr Carney can point to his proactive policy measures as taking control of the narrative around the UK economy and helping prevent a more adverse reaction to the June vote. The fact that the UK’s robust performance goes against an attempt by the then prime minister and chancellor to convince people there would be a severe economic shock from a Leave vote, suggests that the prevailing narrative was already not pessimistic. Of course, when Article 50 to leave is triggered by the government to begin the formal process of leaving the EU, there may be more pressure on sentiment, but in politically-charged times it is necessary to be wary of being phished by political narratives.
As it turned out the arguments about economic stability employed by Remain campaigners such as David Cameron, George Osborne and the Financial Times were secondary to the arguments about sovereignty and controlling immigration championed by Nigel Farage, Boris Johnson and The Daily Mail. The acrimony surrounding the vote has continued, however, and with competing narratives and interest groups arguing over the approach Britain should take to leaving the single market, hyperbole on both sides of the debate is still making it difficult to pick a narrative to follow for the UK economy.
Ropes and beeswax: an Epic solution to not being misled by narratives
To conclude this discussion, it is appropriate to cite a passage from The Odyssey by Homer, the second great epic of Western literature (after The Iliad) as representative of the course of action investors should take when faced with conflicting narratives. The analogy is borrowed from behavioural finance guru Greg Davies, who likened the course of action investors should take to mitigate their cognitive biases to Odysseus’s behaviour when faced with the seductive song of the Sirens. It was said that sailors would leap overboard to their deaths when they heard the beautiful song of the Sirens, so in order that he might hear them and not be doomed, Odysseus had his men tie him to the mast of his ship. So the crew would not be tempted, Odysseus had them fill their ears with beeswax as they rowed by the singing witches.
The moral of the story is that having understood the risks he faced, Odysseus was able to take steps to override his destructive impulses to dive overboard towards the Sirens, but also manage to hear their song. The same principles are true when setting up your portfolio to be robust in the face of whichever investment narratives take hold. Understanding the cognitive biases that you have when putting together your portfolio can prevent you from allowing those instincts to be phished by narratives – either those that prevail in the stock market or the narratives of politicians that create noise and can lead to damaging temporary uncertainty.
That is not to say that investors shouldn’t ride periods of mania – sitting on the sidelines can be costly in terms of missed gains – but precautions should be taken for when the music stops and investment narratives change. At the end of the 1990s, you would have missed out on huge gains by being a portent of doom for tech stocks. Returning to the analogy of Odysseus, the key would have been your ropes and beeswax – how do you guard your overall portfolio for when crashes happen? There is no perfect answer to this question as, fundamentally, any return premium is the pay-off for risks, which sooner or later may be realised. The best answers we do have, however, are actually quite simple: maintain a balanced asset allocation, cover your likely liquidity needs (ie have cash for regular expenditure and emergencies) and stay invested.
If you can afford to do all of that, then politicians and fraudsters can lie all they want as – barring thermonuclear war – the overriding human narrative of optimism will probably win out in the end.
