Economic Theory Wrong?

Posted on July 18, 2008
Filed Under Politics, Science |

Interesting article up at New Scientist. (It’s behind a pay wall so I’ll summarize it) It’s about why economic theory is out of whack. The paper they are discussing is available at arXiv though. It’s “Stock Price Jumps: News and Volume Play a Minor Role”. (OK, not a very catchy title) Roughly they studied jumps in stock prices and then relevant news. They found most jumps weren’t associated with news and most relevant news didn’t cause jumps. However traditional economic theory says markets are generally in equilibrium due to a balance of economic forces. Markets change when forces change. In theory this means good news or bad news ought to reflect in the market. However this isn’t what is going on suggesting either an unknown internal dynamic or that forces are more subtle than assumed.

Now I’ll confess I don’t know a lot about economic theory. (Hopefully someone who does can chime in) So I can’t say much.

Here’s what the article says, talking about the recent housing bubble.

Some economists have long argued that the movement of opinions and information between people tends to amplify market movements, leading inevitably to fat tails. Bouchaud and colleague Olivier Guedj found strong evidence for the idea four years ago. Using data on analysts’ forecasts of US, European, UK and Japanese stock earnings over the period 1987 to 2004, they looked at how well their predictions had turned out. The data showed, for starters, that they were generally over-optimistic - so much so that a more successful strategy would have been simply to assume that the following year’s earnings would be the same as the current year’s. Tellingly, Bouchaud and Guedj found that the analysts tended to make forecasts that were similar to those other analysts had already announced, even when this went against available information (www.arxiv.org/abs/cond-mat/0410079). They flock like sheep in Prada shoes.

They then discussed a bit other alternatives including those focusing in on chaos.

Sornette and Harras found that, as in any real market, prices in their artificial market never completely stabilise but continue to move up and down more or less chaotically. The researchers could, however, do something that is impossible in a real market: look at how individual players’ decisions were linked to those ups and downs. This showed that the public and private information tends to keep prices around realistic values, as the classical equilibrium model says it should. The joker in the pack is information that flows through social networks, and gets spread by word of mouth. This, it turns out, creates groups of people coordinated in their actions, which in turn leads to bubbles - stocks that become priced too high or too low. Curiously, these bubbles can triggered by nothing more than a random streak of news, which then becomes amplified by social feedback.

The model is also providing insights into the origin of market crashes, suggesting that here too received wisdom is wrong. Most financial analysts look for the origins of a crash in specific events immediately beforehand. Sornette and Harras’s model, by contrast, indicates that is has more to do with a progressive linking together of investors’ decisions and expectations over months or years. This reinforces any problems - which in turn leads to general market instability (see “Financial flocking”). Eventually, Sornette reckons, the markets reach a state like an avalanche waiting to happen. “Anything can trigger the avalanche once the system is ripe,” he says.

This kind of instability may have a lot to do with the events that triggered the current credit crisis. In recent unpublished work, Thurner, Farmer and Yale University economist John Geanakoplos have developed an agent model of the securities market that includes hedge funds, banks and ordinary investors. The model’s hedge funds try to identify momentarily mispriced securities, and make a profit by buying or selling in the expectation that the price will return to a realistic value in the future. As in the real world, they “leverage” their investments by borrowing from the banks.

The simulations have revealed some alarming consequences of this kind of activity. With no leverage, a hedge fund can only lose its own investors’ money, but as leverage increases it can also lose money it has borrowed from a bank, possibly putting that bank into difficulties. “Lots of leverage begins to pose the threat of failures cascading through the market,” says Thurner.

Intriguingly, the risk of cascades like this occurring doesn’t increase gradually. Things go smoothly until the amount of leverage reaches a certain threshold, at which point the model shows the market undergoing a sudden change, loosely akin to a physical phase transition, like water freezing into ice. Increasing levels of credit create stronger links between market players, heightening the chance that the failure of one can put an unsustainable burden on others, triggering further failures. In the simulations, once the level of leverage passes a certain threshold, it becomes overwhelmingly likely that a single chance failure will send waves of trouble through the entire market. Avoiding future crises will mean identifying where the real-world market’s “freezing point” is - and keeping levels of leverage low enough to steer clear of it.

New Scientist also had an editorial on some of the implications of all this.

Comments

12 Responses to “Economic Theory Wrong?”

How is this not just a condemnation of the news media? If real-world prices don’t match news reports, could it be that journalists are reporting on the wrong things? (or under-informed, or reporting what they read elsewhere, etc.)

2 Coffinberry on July 19th, 2008 5:23 pm

I took a course in Venture Capital this past spring, taught by a highly successful venture capitalist. My law school (in conjunction with the B-school on same campus) sponsors some very interesting entrepreneurial activities, including Start-up Weekends and New Tech (and Green) MeetUps. What I see happening, through the stories of our instructor and participating in the MeetUps is the kind of bubble-event build up that this article warns about. As a matter of fact, for this crowd, Web2.0 is everything, and life is all about social connections and getting the latest Twitter (and Twitter app), because you never know when it will lead you to the next big deal, the next hot launch, the next big bucks. The problem, I suspect, is the closed-loop nature of their networks. The network is big and vibrant and spans the country. But it spans a relatively narrow slice of the population as a whole. The potential for a feedback screech (think putting a mic too close to the speaker) is huge. When I think of the multi-millions being fed into the venture capital system based on this (and similar) networks, I feel good cause to worry.

Brian, it’s not just bad reporting because even bad reporting ought have an effect but doesn’t.

But that’s only if the people hearing the bad reporting believe that it is good reporting.

I’m not supporting either side of this argument, just asking the question.

There is no reason to believe that business news per se is a dominant factor in equity pricing. In particular, by the time the press gets around to reporting something relevant to the prospects of any given industry or company, it has generally been well known among serious investors for weeks, if not years - no inside information required. Most of the time business news is very much a lagging rather than leading indicator of stock prices.

This is not exactly a contravention of traditional economic theory, but rather a confirmation of it. In particular, the news is *not* an economic force. At best it is but a belated messenger.

Most people who have done any serious trading in equities will tell you “news” doesn’t affect price all that much. By the time any news comes out, all of the insiders and big players already know about it and have positioned themselves to profit from it. At best it’s just a catalyst for a move already waiting to happen. A good news induced jump in a weak downtrending stock will frequently be retraced within a few trading sessions. Biotechs tend to be heavily news driven, but for most other sectors it’s not as relevant as most non-traders seem to think.

It’s be interesting to see a study that separates out “predictable” news from impredicable news. My sense is that the latter ought affect trading but judging from what I’ve read of the paper that doesn’t have an effect either.

I think the problem is that most business news is not really unpredictable. In theory (if you subscribe to fundamental analysis) earnings announcements should be big movers, but frequently a stock makes a large move ahead of earnings, then does nothing or sells off on the actual announcement. Because markets are so heavily forward discounting, any news tends to be priced in before you can respond to it.

Of course, mainstream news reports will always try to focus in on a reason why the market went up or down. I guess you can’t really blame them, after all they are news reporters and that is the paradigm they are working in. But markets are primarily driven by fear, greed, and panic. This also tends to be the weakness (IMO) of many academic studies of market behavior–they fail to account for the effects of human behavior by assuming market participants are completely rational entities.

9 Gerald Smith on July 21st, 2008 11:50 am

Don’t we get the same possible bubble occur with free trade/free markets? We sought free markets between the states for years, convinced that mercantilism would prevent the maximal ability for trade and manufacturing. But for the last couple decades, we’ve looked more and more at international markets and free trade. Will we not see this same kind of bubble eventually occur, when we see jobs move from one country to the next in an attempt to find the cheapest labor, until eventually there will be an equilibrium where no one makes any money?
IOW, after a group/sector of stocks hit their bubble limit, the bubble bursts (tech stocks a decade ago, housing stocks now), and there’s are a lot of floating carcases left to rot. Will free trade do the same things, as the US tech bubble moved to India/Russia/China, and now much of it is moving again to cheaper countries? Will such equilibrium eventually come back around to a cheaper USA, where we will once again be involved in low level industry and manufacturing, since no one will be a leader over any other country?

Actually Gerald it’s interesting but US manufacturing has been increasing despite the whole offshoring debate. The number of jobs has decreased but that’s primarily due to significant innovation in productivity in the US. I’d suspect that if these jobs left India/China though they’d merely go to other nations. (There have been stories of many companies leaving China and going to Viet Nam and other nations for instance) It really depends upon the productivity.

As to whether this would generate a bubble - perhaps. Although with both the .com bubble and the housing bubble it was the increase in perceived profits that made people neglect common business sense that was at fault. (i.e. lots of business models that were obviously unsustainable but worked only because of speculators pumping money into the market) While aspects of that can happen in the general free trade I think it’s hard to say something that general can be a bubble. But some things, such as tech support, clearly are swinging around.

Nassim Taleb’s books (The Black Swan; Fooled by Randomness) are an entertaining expose of the hasty lines drawn between economic ’cause’ and ‘effect’ by well-meaning but clueless rationalists (academics, economists, journalists, and even ordinary business-folk). People want the markets to make sense, so they gather mounds of data and mistake random noise for meaningful movements until an unforeseen disaster sinks their proverbial ship, which they have left too vulnerable by rating their understanding of marketplace realities too high.

There is an idea in some schools of economics regarding activity of The Fed. The Fed is only able to affect markets when they do something unexpected. Thus if they are supposed to cut a key rate, and they do, then the market has already priced this in. However if they raise when cuts are expected the market will move to reflect this unexpected new information. This may be the case with business news as well, so if a CEO dies of cancer, it is expected, but if a young CEO dies in a car crash, this is unexpected and should affect prices.

Alternatively there is a relatively new idea that information has a cost so the assumption of perfect information must be discarded, thus the cost in time and effort to stay current on the news may not be worth it, or it may be so worth it that people develop other sources that provide information before a news story.

A third possibility is market failure. A market fails when it does not allocate resources optimally. Not pricing in information that should affect prices would be a market failure. Imperfect information, no competition, government regulation, externalities, and outright manipulation could all potentially cause market failure.

Leave a Reply