US debt crisis: The market take off that wasn

3rd August 2011

Markets are complex, in every sense. They have "emergent" properties; movements are the "bottom up" product of millions of decisions – like an ant colony. They are not a "top down", or planned, process.

They are interlinked, events in one area can affect another in unanticipated ways and those effects can feedback into the first in unexpected ways, and so on.

Of course they include people, en masse, which involves one of the most complex, non-linear, self-organising systems on the edge of chaos that is known to exist.

So why would anybody expect a simple explanation of market movement – or non-movement?

Consider people. 

Nobody, however expert, can actually predict the future accurately. So we make guesses.  Possibly educated guesses, from the best minds manipulating the best data using sophisticated mathematical formulae in super-computers and based on amazing stores of data (rather like weather forecasts, in fact) but still guesses.

These guesses or (more positively), market predictions, are, theoretically, about future income streams. Theoretically people invest money now to produce income in the future.  Logically, we'll pay more now for something that will produce more income in the future.  Capital growth (again theoretically) represents the growing confidence (subjective estimate) that income will go up faster or more than expected (expectation = guess) and therefore the stock is worth more now. 

We'll ignore the obvious flaws in theory here, like the fact that if people actually operated like that, we couldn't get bubbles in markets (as the Nobel Prize winner Eugene Fama once stated as fact about the US property market), and that since the markets are subject to unpredictable movements (who anticipated the market fall consequent on the Japan earthquake or the rise on the news of Bin Laden's killing before they happened) the anticipations, predictions, expectations, guesses or complex calculations are subject to random error.

In reality, market predictions are not about future income.

People buy not what they think will necessarily produce the most income in the long term future (which they don't know anyway) but what they think somebody else will give the most for in the short term future.

This is, at least partly, because the shorter the term, the less the potential error in prediction. The tendency is for theoretical future income to become less important to the investor than the anticipated capital growth from selling on short-term the potential for future income long-term. 

Rather than any obvious problems, let's look at the abstract problem of "investor confidence". 

The market movements result from millions of decisions.  But when everybody has the same facts (whether they are actually true or not) they will tend to make the same decisions.  At the end of July, the media, NYT, International Business Times etc. were saying the US could not possibly default and that investors were confident that the storm will be weathered. This morning the BBC says that markets hadn't lifted on the last minute debt ceiling raise.

Some are surprised that the market hasn't risen, whereas the obvious conclusion is that nobody really believed there would be a default, had already assumed there wouldn't be, the "investor uncertainty about US debt holding down prices" was basically hype and prices were where everybody figured they should be.

That is the obvious solution to market immobility.

The abstract solution is that prices are not based on what individuals think themselves anyway. 

Markets use supply and demand. If lots of people want something, (they think it will rise in price short-term) they will pay more for it.

If you want capital gains, you don't want the stock you like, but the stock other people want.  Consequently you need to know what other people want because other people think it is going to be rising in value. That's what you want to sell them.

Consider a prize for predicting the winner of Strictly Come Dancing at the start. To win the prize, you don't vote for the person you believe is the best dancer, you vote for the person you believe other people believe most other people will vote for. If there is a prevalent view in the media as to who will win, you vote for them on the basis that that is what most people will do, so they will indeed win.

If the media say something is impossible, irrespective of what you believe about future income streams etc. it is pretty much axiomatic that you'll "vote" the way everybody else does, because that's the way that you make short term, future capital profits in the same way as you would win the prize on Strictly.

And if the expert view is wrong, the hype is wrong etc. we get "unexpected market collapse" or some tearful TV event.

It's lots of things, but it isn't simple.

Kim Stephenson is an occupational psychologist and trained financial adviser.

His website Taming the Pound is aimed at helping people get control of their thinking about money, so they can use their money – and avoid their money using them.

 

More from Kim on Mindful Money

Finding an honest advisor needs an honest approach from investors

Financial regulation: Why bother at all?

The fairer sex? When it comes to business men and women are created equal

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