Why markets aren’t – and are – rational
A guest post from Constantine von Hoffman, veteran business journalist and author of the blog CollateralDamage.biz, a humorous look at marketing and business.
News reports about yesterday’s 679 point drop in the Dow all blamed a study stating what was self-evident: We are in a recession and have been in one for the past year.
“The stock market suffered one of its worst days since the start of the financial crisis Monday as investors responded to a string of bad economy news by fleeing to the sidelines. Among the day’s events: confirmation that the U.S. has been in a recession since December 2007. ”
The problem with that explanation is that it doesn’t seem to make any sense.
Aren’t markets supposed to factor in widely available information and thus be “rational”? To believe that explanation means accepting the idea that investors (and thus markets) are totally clueless about the actual state of the economy. Did anyone really think we were not in a recession?
When looking at the reason given for the market slide let us for a moment put aside the always plausible argument that many reporters are idiots and publish the first explanation they can understand. (Please note that I say this as one of the guilty.)
Actually, what has happened is that the idea of a rational market has become warped by general usage*. The idea of rational or “self-correcting” markets has suffered from bumper-sticker syndrome. Somehow this became: The markets know best. While journalists are certainly complicit in the spread of this interpretation, it is rooted in conservative ideology and has been used to further the argument that government economic regulation is bad.
For economists, the word rational is only applied to markets when joined with the word expectations. It was coined by economist John F. Muth to describe the many economic situations in which the outcome depends partly on what people expect to happen.
In the case of yesterday’s market plunge, the markets were rational in that they lived up to everyone’s expectations. For some reason people briefly saw the announcement of a new Treasury Secretary as a reason for hope and thus the dead cat went up. This idea didn’t sit right with a lot of people – myself included – so investors used this report as a reason to move the markets back in line with their expectations. (Wait, did I just say the press may have gotten one right? Sort of. You know what they say about broken clocks, though.)
In case you haven’t had enough bad news ponder what people’s current expectations mean to the housing market.
*Sort of like evolution. The bumper-sticker version of evolution is: Survival of the fittest. In many people’s minds this has come to mean, “those who survive are the best.” In this usage, “best” has a moral connotation and implies that other species are inferior. In fact, evolution actually means: Species survive who can best fit into a particular ecological niche that allows them to prosper. (But try getting that on a bumper sticker.) Actually, the “fittest” animal on the planet today is ithe cockroach. There are at least 4,000 species of roach, fitting into more niches than you spray a can of Raid at. Feel free to declare them the best if you’d like.