Rash Assumptions

This past June, well before the markets crashed and burned, I attended my college reunion. My wife and I opted to take several courses presented by the university, including one particularly fascinating presentation by the Yale School of Management. You see, this esteemed institution had set about challenging the underlying assumptions that the stock market was based on rational economic analysis by persons who would consider financial indicators and then respond in their own economic best interest – a theory that had governed institutional investment analysis almost since that profession was created.

What they found suggested that while professional investment institutions generally engage in such rational numerical evaluations, pure economic analysis seldom generates the kind of market predictability that the traditional theory noted above would project. As I watch this current vacillating market, read what bright analysts had predicted, the psychology of the marketplace seemed to have caused the meltdown – over-confident analysts side-stepped economic common sense to join the herd of financial institutions that profoundly overvalued the obviously flawed derivatives marketplace – and sustained popular mythology (real estate can only appreciate) that made sure that this will be a long hard recovery. In the world of a famous screenwriter, “Nobody knows anything.”

Yale had studied variables such as “over-confidence” in citizen day-traders, finding that these non-professionals tended to under-perform the marketplace (while stating that they were in fact over-performed), back when day-trading was a vast horde of stay-at-home millionaire wannabes. 70% of people surveyed placed themselves with above-average intelligence, an obviously incorrect definition of “average.” After tracking the prediction of election victory between popular candidates, where the “who’s going to win” question equally split those surveyed; a follow-up survey of the same sample after the election that posed the “did you accurately predict the election” produced a 70% “yes, I did” result.

As Yale published their results, analysts at some of the investment banks began to use Yale’s tracking system – which measured the psychological factors – adding these non-economically rational elements to their value analysis of the marketplace, and their predictive assessments improved… until the irrational factors began to level the value of the psychological variables – the markets seemed to veer once again towards the traditional rational explanation – as the professionals accessed this new data. But psychology still seems to be our leading economic indicator.

In the January 16, 2009 New York Times, David Brooks wrote: [A]n economy is a society of trust and faith. A recession is a mental event, and every recession has its own unique spirit. This recession was caused by deep imbalances and is propelled by a cascade of fundamental insecurities. You can pump hundreds of billions into the banks, but insecure bankers still won’t lend. You can run up gigantic deficits, hire road builders and reduce the unemployment rate from 8 percent to 7 percent, but insecure people will still not spend and invest.

The economic spirit of a people cannot be manipulated in as simple-minded a fashion as the Keynesian mechanists imagine. Right now political and economic confidence levels are running in opposite directions. Politically, we’re in a season of optimism, but despite a trillion spent and a trillion more about to be, the economic spirit cowers.

To me, searching for answers in a sea of “battling experts” who seem to disagree about what to do, when to do it and where to target recovery capital – who predict what will happen with a certainty that is reminiscent of what got us here in the first place – I recall that magnificent hour I spent at the Yale School of Management this summer. First, the psychology of the marketplace will ultimately determine both the timing and rate of any economic recovery far more than any other variable, second, that even the experts are driven more by doctrines and psychology than rational thought (though they seek comfort in interpreting data to suit their theories) and, third, that William Goldman, that philosophical screenwriter referenced above, could just as easily have spoken above the financial markets: nobody really does know anything. They just appear to know what they are saying… including me.

I’m still Peter Dekom, and I am still wondering.