What’s Going on in This Crazy Market? Nobody Knows
first published in The Street | Nov 2, 2015
The market went into what seemed like a material tailspin in mid August, a fall of over 10% in the S&P 500 in less than 10 days, starting on Aug 17.
Pundits and observers talked of many factors — the end of the bull market, the China crisis having a global impact, the still relatively modest growth in the U.S. economy. Others said that this time investors should be careful not to buy on the dip; they argued there had been a fundamental increase in risk aversion or the discount rate in the market. Analysts noted that the gap between Baa-treasury and Aaa-treasury spreads had doubled in the last year to an average of approximately 120 basis points. This was, some argued, another key sign of a fundamental shift in the market toward risk aversion.
Others talked of the energy sector sinking under the weight of collapsing oil prices and the strong dollar damaging U.S. exports. Still others have argued we have had GDP growth — albeit modest — in the U.S. for some length of time (six years since the technical end of the Great Recession), and this is longer than the average period between recessionary periods since the war. So, surely, another recession is due?
Of course, what has happened since was, in a way, easy to predict: The pundits have basically been wrong and nothing has gone as anyone predicted. The S&P 500 is effectively where it was back in mid-August before the fall. You could have gone to sleep for two-and-a-half months and woken up and believed the market had hardly moved in that time.
So, what are pundits saying now? Some have just brushed aside those worries of a couple months ago. China is slowing, but China is still not globally significant enough to bring down the whole U.S., the dollar strength is sign of the relative strength of the U.S. economy compared with other regions in the world, and anyway some argue the dollar will settle and weaken again in the new year. Oil prices are stabilizing and from a macro perspective low oil prices are good for the overall U.S. consumer and corporations. So, everything is fine after all and you should have bought on the dip, perhaps.
Others try to give what (at first blush) appears to be a more nuanced view. The likes of Nobel Prize-winning economist Robert Shiller argue that as consensus in the direction of a market slowly changes you inevitably have increasing volatility (increasing dips of greater severity) as investor anxiety slowly builds. The ongoing and larger dips and rises indicate growing indecision in the market, “as time goes on, the stories justifying investor optimism become increasingly shopworn and criticized, and people find themselves doubting them more and more.” Eventually this volatility will amount to a fundamental shift in market sentiment and we will enter a bear market, or so the punditry reads.
Well, what does all this actually tell us? It rather sounds like a huge amount of muddle to me. And I don’t just mean confusion in the market. I mean a virtual disintegration of the coherence of most market commentators. These types of significant dips and then sudden recoveries confuse analysts entirely and are truly an indictment of the so-called “science” of finance.
The pundits who called the end of the bull market back in mid August have already been proven wrong. This bull market will no doubt come to an end some time (maybe even soon), but it didn’t in mid-August. Meanwhile, those saying we are back on track for an ongoing bull market having now seen the recovery cannot be speaking with any type of conviction. With such a dramatic market adjustment just behind us, can they really be confident that the factors which drove that correction are all now past? If they’re students of even recent history, they shouldn’t be.
In some ways, Shiller’s supposedly wise pontifications are the weakest of them all. He is effectively saying that “well, sooner or later the market will break.” Right, brilliant — of course it will. Any one predicting a bear market will be correct — eventually. But what matters is the timing, about which he has little to say.
In the background of all this is another confused group of people, the Federal Reserve’s Open Market Committee, who are probably desperate to raise rates, but haven’t had the nerve to do so in light of such conflicting economic and financial facts.
It has been a period of two-and-a-half months where most pundits have had close to no unique or substantive insight into the market’s future direction. It appears strongly to favor those who argue that highly liquid securities markets are indeed a random walk. To re-jig Churchill’s Battle of Britain quote: Never have so many people contributed so little to so much.
There is a central epistemological problem here: Why is it that virtually all these commentators have no idea what is going on in the market? This is an old financial question and is linked to many factors: the inability to assess the group behavior of millions of moving parts (people); the self-referring nature of human prediction; the differing nature of people’s predictive time periods (some are claiming to give short term views, while others are claiming longer term insight); the psychological irrationality in markets per the behavioral economists; etc.
The problems seem insurmountable and virtually certainly show there are just fundamental epistemological limitations to financial and economic science. It will never be a science akin to physics, always more a craft (and see, on this very point, Dani Rodrick’s new book, Economics Rules: Why Economics Works, When it Fails, and How to Tell the Difference). There will never be answers to many financial questions.
The big take away shoudl be “modesty,” something Rodrick also sees as important for economists who are true to their discipline. Philip Tetlock and Dan Gardner in their recent book Superforecasting, The Art and Science of Prediction, tells us that under the right practical training we can improve our human predictive capabilities. Perhaps this is true.
Nevertheless, the level of epistemological fog in these market conditions seems so deep that, while some may occasionally see some economic light, and some may periodically make some good investment calls, most will eventually be confounded in one view or another.
Joseph in the Bible, we are told, was given a vision of the economic future by God and not by the rest of us. Those who have the integrity to recognize that their financial insights will always be constrained (as humans, we are all very ungodly indeed) are perhaps the ones we should most admire.