News, Reflections and Ideas

Introduction

In the previous blogs we have looked at big, macro issues and how these might feed through into stock markets and investment decisions. In this blog we take a very different angle and move from the macro to the micro. While the economic and financial press tends to focus on broad brush trends (e.g. the cost of living crisis), the trends we see are the result of billions of individual responses to economic, financial and social ‘events’. How we respond as individuals en masse, eventually drives the ‘macro’ trend. At any one point in time, individuals can respond in many different ways and the macro trend is, therefore, difficult to predict – we really do have fundamental uncertainty as to how situations will pan out.

In the following news section we will use inflation and the cost of living crisis to illustrate how fundamental the uncertainty is at any one point in time. We will then use the reflection section to discuss the importance of stories and how they influence financial outcomes. This builds on some of the work of David Hirshleifer (President of the American Finance Association) on the importance of social transmission for financial markets but it also goes back to the work in social anthropology on how tribes/people try to make sense of what they observe. It is also related to MacKay’s seminal work on the Madness of Crowds. We will finish the reflection section with a brief discussion of some of our current work on social media and stock markets.

News – Cost of Living and Inflation

Pick up any newspaper and/or look at the news on the internet, TV, etc. and you will struggle to avoid discussions on the cost of living crisis – how people are suffering, what are the causes, what is the role of the govt, how can the govt deliver soften the blows, etc. And, of course, there are lots of comparisons to the 70s. We have had the good (??) fortune to live through this period and while there are remarkable similarities (a silver jubilee and a platinum jubilee, seeing the end of the Vietnam war and living with the war in Ukraine spring to mind), there are also remarkable differences (the global economy, the connected world, generally better health {though the NHS is in a perilous state}, etc.).

One factor common to all periods is, however, the fundamental uncertainty we have to face as individuals – though periods of uncertainty can be heightened depending on what is happening. For example, we have just lived through the nightmare of Covid and few of us could easily predict how this would eventually impact the economy and, of course, few if any predicted the compounding effect of the war in Ukraine. Let’s consider flying as an example. After years of lockdown most would have predicted an uptick in foreign holidays as a consequence of pent up demand and the removal of restrictions. Not many of us, however, predicted the chaos in the airports as they and the airlines did not gear up to respond to the new demand. How this current chaos affects foreign travel going forward is hard to predict. Will people see the chaos, cancel their flights and return to staycationing? Will their pent-up demand for sun trump the chaos and will they persevere? Will the govt become involved and put sufficient pressure on the airlines and airports so they sort their acts out? Will the chaos coupled with the cost of living crisis dampen all enthusiasm?

The uncertainty over foreign travel is added to by the decisions households are having to take to deal with the cost of living increases. In all of these decisions they are having to make ‘guesses’ on current spot prices and expected prices when making big decisions. Do they lock into what seems a high fixed utility tariff? If they predict further price increases, they will lock in. Even if they struggle to make any real prediction, they may lock in to give certainty to a big piece of household expenditure. The same thinking applies to all big expenditures – cars, houses, holidays, etc. With small decisions we tend to go with the flow as we don’t have the time to agonize over every decision we make in the day.

Let’s consider the unecertainties over houses and cars. The climb in house prices has been remarkable, especially over the Covid period. No one predicted the price rise and the effect of people focusing on housing during this difficult period. In many ways UK house prices defy logic and gravity – people pay significant parts of their net income on housing seemingly in the belief that it is a superb one-way bet (supported by a lot of evidence) and not allowing for the costs of mortgage payments spiralling out of control. All recent evidence suggests people are being rational but if you look far enough back, there is evidence that booms turn to busts and cost of living hikes can be the determining factor in deflating excess demand. Essentially, large mortgage costs seep into the psyche of the population and those seemingly wonderful housing assets become expensive liabilities. However, such turns in sentiment take a while to take hold and at this point in time, it would be a brave man who predicts a housing downturn given the number of failed predictions over the past decade.

Similar uncertainty affects cars. Should you buy now? Some are predicting an easing of supply and a reduction in price, others are arguing that there has been a fundamental shift in the attitudes of manufacturers as they move up the market to make better returns. There is also the complicating factor of the move to electric cars – which tend to be expensive to buy but relatively cheap to run. The development of electric cars is clouding the market and clarity over what seems a reasonable price seems to be misting over. Many discussions are now taking place to try to make sense of where the car market is going and as humans, we use stories to make our point and make some sense of how we respond to fundamental uncertainty. We now turn to the power and influence of stories.

Reflections – Stories from Beginning to End

With a bit of thought it becomes clear that stories are a huge part of human life. We tell our children stories to help them understand important moral and ethical issues, we use them to praise/condemn fellow human beings, we tell stories to convince others of our beliefs, etc. (the Bible is full of them) and we tell stories of the departed to deal with the grief we feel and to cement them in our memories. In short, human life can be characterized as the story of storytelling.

Given their key place in our very existence, it would be strange in the extreme if stories did not feature in financial activities and markets. Not surprisingly, stock markets are full of stories – every major shift comes with a story/explanation. Just consider the many stories we have had to witness regarding why fortunes have been made via cryptocurrencies and why these fortunes are the outcome of rational decisions and not just dumb luck.

Stories need not be fantasies and can be quite helpful in us making sense of what is happening – this is how we use them to teach children. Psychology, sociology and anthropology have all spent time trying to understand how humans use stories; in contrast, economics has largely ignored them and focused on the rational individual acting in an atomistic way and largely adrift from the rest of humanity. But once we start to understand that stories are a key part of how we operate, we have a greater insight into how markets work.

The social side of human decision-making has been highlighted by David Hirshleifer in his Presidential address to the American Finance Association in 2020. He recognises that we observe and talk to each other, and in the process of doing so we create a Social Transmission Bias. The stories we tell (and how we tell them) can be selectively adjusted by the sender and the receiver. Essentially, we have Chinese Whispers. Hirshleifer produces many fables and themes to illustrate the power of social transmission but here we will focus on just one – social transmission compounds recursively – through transmission small issues can become large – mountains and molehills! There are many features to this compounding but one that is very important to financial markets is the notion of extremes brought on by narrow bandwidths of transmission. In such markets we are unable to send highly nuanced signals and the simple signals are likely to be further simplified through transmission and this can lead to extreme conclusions – booms, busts, the importance of social media to elect and destroy presidents, etc.

In financial markets this notion of simple messages seems to have partially underpinned the focus on growth stocks as being the only way to make serious money after the financial crisis and the ignoring of so-called value stocks. BUT as we all know the separation of growth and value is, in many ways, a false dichotomy. Stories are powerful and we are easily swayed by a good story – but if we are to stay solvent, we need to be able to interrogate the positives and negatives of any specific story. This ability is ever more important in the social media we now live in. Stories can be created and transmitted to millions with few checks on their veracity – just consider how many times Facebook has had to apologise for the damage it has wreaked.

Finally, we have a habit of listening more to bad than good news (just consider why this might be a feature of survival and evolution) and, not surprisingly, our recent work on Instagram posts suggests negative media sentiment seems to drive financial returns more than positive ones. Here, there are more complications – it takes a while for the posts to feed through to prices and eventually (after a few months), people understand matters have been driven too far and prices revert. In short, a good story sells but it will only keep selling if there is some truth to it – as humans we have been trained from an early age to both believe and question stories and this is no bad thing.

Idea – What happens after market pessimism?

Many investment ideas are based on the notion of a market cycle created by greed and fears. However, it is an equally challenging task to understand the state of mind of the crowd as to understand the financial market. In this idea section, we look into one simple illustration of how the knowledge of detecting a potential market panic may be useful in improving longer-term returns.

The idea is based on the observation that social transmission will compound the news and leads to an extreme conclusion by the crowd and this is especially true for bad news, as fears catch disproportionally more attention. To identify such a market state, we distil it down to the following description of the market: when the narrative of the market is bad news and everyone agrees, the market goes down a lot with little volatility. We can loosely define this as market pessimism.

To illustrate this, we look into the monthly return of the S&P 500. We define a 5% market drop (ten percentile in the sample distribution) with volatility that is less than 20% as the market where investors agree on bad news. This accounts for 3% of the sample which is 10 months out of the 323 months in the period between June 1995 and May 2022. What we are interested in is what happens next.

First, this bad news state will be more likely to continue when compared to the same magnitude of price movement but with a larger disagreement. The difference is economically large. There is a 1% further drop in the index following the low disagreement, while a reversal of 0.3% following the large disagreement. This demonstrates the momentum created by the agreement of the crowd. This is also unique to large price drops but not to a large price increase.