In 1967 Bibb Latane and John Darley, two academic psychologists, asked some undergraduates at New York University to sit alone in a room and fill in some questionnaires. While they did so, they pumped smoke into the room. Three-quarters of the students, as you’d expect, soon noticed the smoke and raised the alarm. They then repeated the experiment, with the difference that each student was in a room with two accomplices of Latane and Darley who had been told not to react to the smoke. Only 10 per cent of students then raised the alarm.
This experiment tells us that our reactions to events are shaped not just by reality but by those around us. Even when our life might be in danger, we are less likely to react if others don’t.
Last week’s sell-off in US equities reminded me of this. We’re told that the fall was due to worries about higher bond yields. In itself, though, this is no explanation. Ten-year US Treasury yields rose steadily between September and January, and yet shares rose nicely then.
This didn’t happen because bond yields rose because of expectations of stronger economic growth – something that’s good for equities. If this had been the case, the US dollar would have risen. But it didn’t.
More likely, the explanation is Latane and Darley’s. Each individual investor was untroubled by rising bond yields because others didn’t seem to be concerned. What matters in stock markets is not reality, but others’ perceptions of it. The trader who dumps overpriced shares will do badly if others continue to buy them, a fact that incentivises him to go with the herd.
As Chuck Prince, then chief executive of Citigroup, said of bank lending in 2007, “as long as the music is playing, you’ve got to get up and dance”.
Maynard Keynes wrote in 1936 that investing is a competition in which traders try to forecast what average opinion will be. This is a big reason why we see excess volatility and momentum in markets.
For this reason, it is common for markets not to notice things until they suddenly panic about them. Way back in 1999 Sushil Wadwhani, then a member of the Bank of England’s monetary policy committee, said of exchange rate crises that “current account deficits don’t matter – until they suddenly do”. US house prices began to fall in 2006 but it was months until markets panicked. And there were external imbalances in the eurozone for years before bond yields in southern Europe shot up in 2011.
Last week’s sell-off in shares after months of not worrying about bond yields, therefore, has plenty of precedent.
The trigger for it was the news that wage inflation last month jumped to 2.9 per cent, its highest rate since 2009.
This raises the danger that the Fed will raise interest rates by more than previously thought. Equities hate this, in part because of the fear that higher rates will reduce economic growth, and in part because of the danger that higher returns on cash will reverse the ‘reach for yield’ that has boosted demand for shares in recent years.
Even if we leave aside the fact that the jump in wage growth might be only temporary, there are reasons for investors not to panic about this.
Most significant of these is that inflation has been very stable in the past 20 years: core consumer prices index (CPI) inflation has ranged only between 0.7 and 2.8 per cent despite some huge shocks such as $150 oil prices and the biggest financial crisis since the 1930s. The idea that inflation can suddenly shoot up is refuted by history.
And the global outlook isn’t all inflationary. In China, monetary growth has slowed recently. In the past, this has led to falling commodity prices after a few months.
Even if inflation pressures do develop, however, they won’t be wholly bad for US equities. Higher wage growth – assuming last week’s numbers continue – will sustain consumer spending: it’s no accident that 2017 was a year not only of low wage growth but also of ‘retail Armageddon’. Equally, the weak dollar that pushes up import prices will also boost the profit margins of US exporters.
And if all this fails to support share prices, there’s a further cushion. The Fed often takes its cues about monetary policy from the stock market. If it falls, big rate rises are less likely, which should at least moderate the downside for shares.
All these, however, are incomplete comforts. Last week’s wobble has reminded us that equity markets are fragile and that high prices might be due less to sustainable factors such as the rise of monopoly power and more to the temporary support of cheap money.
In this sense, even though we might not be on the brink of a serious meltdown, we should be concerned about high valuations.
