Stock markets fell last week because of fears of a second waves of the pandemic. So we are told. You can be forgiven for finding this odd. We’ve all been warned for months that such a wave was likely. So why does the market seem to have been surprised by this?
It’s because 'the market' is not a person: Benjamin Graham’s talk of “Mr Market” was a misleading metaphor, at least in this case.
Instead, share prices are emergent: they are the unintended outcome of countless individual trades. And these trades are based not just upon traders’ beliefs about the world, but upon their beliefs about what others believe (and, indeed, about what others believe that others believe, and so on). It would be more accurate to say that shares have fallen not so much because of fears about a second wave, but because traders who had previously thought that others were looking forward to recovery now fear that others will fear a second wave.
It’s quite normal to act upon what we believe others will believe. The IC pays me in a series of ones and zeroes transferred from its bank account to mine. I accept this because I believe that people selling things I want will accept ones and zeroes from my bank and credit card. And I believe this because I believe that they’ll believe the same. All economic activity other than primitive barter is founded upon beliefs about beliefs (about beliefs and so on). As the philosopher John Searle wrote in The Construction of Social Reality, “there are things that exist only because we believe them to exist”. The bases of economic life such as money and property rights are among such things.
And it’s rational for any individual to trade upon what they believe others will believe. A share is worth only what others are willing to pay for it. If you believe a company is great while most others think it’s a dog, you are wrong.
The essence of social science, however, is that behaviour that is rational for any individual can have unpleasant emergent aggregate effects. So it is with trading on beliefs about beliefs.
It can cause price bubbles, when people buy because they expect others to buy. For individuals, this is rational: we know that momentum investing often works. But the result is overpricing. This process of course works both ways: it can give us underpricing, too. As Yale University’s Robert Shiller showed, shares are more volatile than external reality in that they move much more than dividends. This is why the dividend yield has been such a great predictor of subsequent medium-term price changes: it tells us when the market is mispriced.
But, of course, markets are not always volatile. Instead, we see periods of relative stability punctuated by bursts of high volatility. This happens because the distribution of beliefs about beliefs changes. When people disagree, we get stability as sellers can find buyers quickly without prices having to move much. Volatility, by contrast, happens when there is widespread agreement – say that banks are in trouble or that Covid-19 will harm economies a lot. In such times prices must fall a lot if sellers are to find buyers.
Excess volatility arising from trading on beliefs about beliefs has another effect, pointed out by Mordecai Kurz at Stanford University. Uncertainty, he said, doesn’t arise only from external reality about economic facts such as interest rates or profits. It is also generated by the actions and beliefs of other traders. Even if you – uniquely in world – could predict the course of the pandemic you could easily lose money by trading on this because prices will be moved by beliefs about beliefs about the pandemic, which gives us two levels on which prices might deviate from those warranted by reality.
It takes more than knowledge of 'fundamentals' such as company accounts and macroeconomic developments to make money. The career of the late Tony Dye showed us this. In the late 1990s when he was a fund manager with Phillips and Drew he thought tech stocks were overvalued. His fund underperformed horribly as these shares rose for months, causing him to lose his job in 2000. Tech stocks then slumped. Mr Dye was vindicated. And unemployed. Knowing the reality can be dangerous if others deny that reality.
Equity traders therefore need more than knowledge of economics and companies. But what? The answer lies in some experiments done at Caltech by Peter Bossaerts and colleagues. They asked people to predict the prices of artificial shares traded in laboratory conditions. They found that the best predictors were not the people who scored best on tests of logic and maths but rather those with good theory of mind skills – people who were able to infer others’ beliefs and intentions from their actions. (This finding has been corroborated by a subsequent study.) Such people are better at forming beliefs about beliefs. There really is such a thing as market feel.
Even for those who have it, however, this feel is far from infallible: there’s a reason why traders want the security of a salaried job rather than the uncertainty of trading on their own account.
Most of us, though, don’t need to trade often, And given that prices are the result of complex emergent forces that are so hard to predict, nor should we.
