Is the Stock Market Irrational?

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Economic indicators might be signaling challenges—such as declines in growth, drops in consumer spending, or rising unemployment, but the stock market is doing pretty well. What gives? Have all these traders been living in a cave ? 🧐 Or maybe they’re ahead of the curve and already know that the economy is on the mend?

That’s a nice thought, but it’s probably safer to stick to Paul Krugman’s three rules about interpreting stock prices:

1. The stock market is not the economy.

2. The stock market is not the economy.

3. The stock market is not the economy.

A lot of the rosy numbers are being driven by big tech companies like Amazon and Apple, who are doing gangbusters with everyone trapped at home. So-called “early cycle” stocks, which tend to be more reflective of the real economy—like cars, banks, and consumer goods—are lagging behind. Thousands of small businesses crippled by the pandemic are not represented in the stock market at all.

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Some economists describe what’s happening as a market “de-coupling,” where stock prices cease to reflect economic realities. Most forecasters now predict a lot of bad numbers in the coming months, yet investors are strangely optimistic. The warning lights are all flashing red, but the market seems to be blissfully unaware of the storm on the horizon. 🌩️

If you’re thinking, “Wait a minute. I thought stock traders were supposed to be really logical people,” you’ve just waded into a century-long debate about the very nature of the stock market. Is it a rational mechanism that accurately reflects what companies are worth? Or is it governed by the touchy-feely emotions and biases that all humans are subject to? 🤔

There’s a long tradition of using emotional phrases to describe the world of finance:

- The Great Depression

- The Panic of 1837

- Tulip Mania

Investors are often described as “optimistic” and “cheery,” or “skittish” and “glum.” Alan Greenspan famously warned about traders’ “irrational exuberance” during the dot-com bubble, and there’s an old Wall Street saying that “financial markets are driven by two powerful emotions: greed and fear.” 😨💰

Yet, for much of the 20th century, the consensus among economists was that the market was perfectly rational and stock prices were always an accurate reflection of a company’s true value. According to the “efficient market hypothesis,” investors react to good or bad news about a company, driving the price up or down until the risk is balanced with the reward. Therefore, in theory, a company can never be “undervalued” or “overvalued.” Since all public information about a company is already reflected in its stock price, it’s impossible to “beat the market.”

Many years earlier, John Maynard Keynes, one of the godfathers of modern economics, doubted that a dispersed pool of investors could really know a company’s true value. He compared the stock market to an offensively outdated little contest the British newspapers would sometimes hold in the 1930s. They would print photos of a hundred women and ask readers to pick the six prettiest faces. The winner would be the person whose choices most closely matched the average choices of all the contestants.

The problem with this (aside from it being an ancestor to Hot or Not) is that shrewd contestants would not pick the faces they actually thought were the prettiest, or even the faces that they thought the average person would find the prettiest, but the faces that they thought the average person would guess the average person would find the prettiest. If you think your head is spinning now, consider another version of this dilemma called the “2/3rds Game.” 🎲

A bunch of contestants are asked to pick a number between 1 and 100. The winning number is the one closest to 2/3rds of the average of all the numbers. So if the average is 50, whoever picks 33 wins. But assuming most contestants can do basic math, they’ll probably choose 33, making the winning number now 22. If most of the contestants anticipate this, they’ll likely choose 22, making the winning number 15. And if they all guess that the others are thinking the same way, they’ll choose 15, and the winning number is now 10. Depending on how clever the group is, the winning number can quickly dwindle down to zero.

These examples illustrate that when people buy and sell stocks, they’re not always trying to predict something as concrete as profitability. Many speculative traders are simply trying to guess what other people will be willing to spend on a stock in the future, which depends on what those people think others will be willing to spend. Much like the 2/3rds game, this can cause a cascading effect of over- or undervaluation.

In the 1980s, Nobel Prize-winning economist Richard Thaler set out to prove that it was possible for companies to be over- or undervalued by building two theoretical portfolios of stocks: “Winners” and “Losers.” The “Winners” portfolio consisted of companies whose stock prices had recently performed exceptionally well, and the “Losers” portfolio was full of stocks that had recently performed exceptionally poorly. His theory was that these movements were fueled by investors being over-enthusiastic about the winners and overly pessimistic about the losers.

If he was right, then all these extreme prices would regress back to the mean, causing the “Losers” portfolio to perform better. And that’s exactly what happened. In survey after survey, the Losers performed better than the Winners, often by a wide margin. It seemed to suggest that stock prices can be influenced by what Keynes called investors’ “animal spirits,” or what psychologists might call “herd behavior”—jumping on and off bandwagons because everyone else is. 🐑

What Thaler had tested was a form of “value investing”—betting that certain companies are being undervalued by the market. The efficient market hypothesis said this should be impossible, but tell that to Warren Buffett. 💼

Black Monday

And then something happened that Thaler believed settled the debate. On October 19th, 1987, stock prices crashed all over the world without warning or explanation. According to the efficient market hypothesis, stock prices are only supposed to change based on new information, yet there was little to precipitate the crash other than that investors all got “uneasy” at the same time. How, wondered Thaler, could a stock’s price be 25% lower than it was the day before and yet both be rational measures of intrinsic value, given the absence of news?

This is not to say that the stock market is pure fantasy. Quarterly reports and profit margins do matter, and you can’t have a high share price for long without something real to back it up. 📈 But the work of Thaler and other economists did convince the financial community that there was some element of human irrationality at play, which could cause market volatility.

So, where does that leave us today? No one knows for sure why the stock market is doing well during an economic crisis, but there are some theories:

1. The federal government has been pouring billions of dollars into the economy—which can act like a shot of adrenaline, even if the underlying economy is weak. 💉

2. There’s nowhere else for the money to go. Bonds currently have very low, even negative returns, so investors have no choice but to focus on stocks. 📉

3. With sports and casinos closed, even gamblers are turning to the stock market as an alternate table to place their bets. 🎰

4. Good old-fashioned FOMO (Fear Of Missing Out). In a time of economic uncertainty, the stock market seems to be the one thing that’s going well, so no one wants to be left behind. 🚀

Whatever the cause of the de-coupling, many experts warn that it probably won’t last forever. A new round of bad economic numbers or the Fed turning off the spigot might pull it back down to earth. 🌍

Does that mean you should get out? Not necessarily. People who hop in and out of the stock market tend to lose money compared to those who just sit tight and wait it out. Richard Thaler’s best piece of advice for investors is to rarely check your portfolio and avoid reading the news. 🛑

The stock market is not an oracle with all the answers, nor a casino where anything goes. It’s a tool for growing your finances, and like most tools, it’s safest to handle when you’re calm and collected. 🧘‍♂️