Not only couldn’t fundamentals justify a real index price growing 270% while earnings only grew 50% from 1988 to 2000. But check the volatility. Prices should reflect discounted value of future cash flows going to eternity. As such, they shouldn’t be much influenced by the current economic cycle (earnings should), but they are obviously much more volatile.
Ok, till now nothing new. This behaviour has largely been attributed to irrationality: panics, greed, cognitive biases etc. But is it all just this? Would you qualify someone who got into the market in ‘96, when P/E was already higher than its historical value, and got out in ‘99 with an 80% real profit, as being irrational? We only can now state that it was obviously irrational buying at the peak or staying in the market through the peak.
Here is thus one first conclusion: there must be some irrational investors for these situations to be created. And a second conclusion: all investors who buy the market at high valuation need not be irrational.
This blog will try to uncover whether there are two different groups of investors: the rational ones and the irrational ones (those who buy at or stay through the peak), and find out what the difference between them might be. It will speak about one way rational traders deal with the task of market timing. It will also tend to support the thesis that people who drive prices to abnormal levels as well as those who make for the price volatility aren’t the irrational ones.
On the chart above you can see that earnings movements rarely precede price, they seem more to move somehow together and this is because they are somewhat interdependent, that is high earnings influence buys but growing prices also influence higher earnings. Financial markets valuations impact the real economy through a wealth effect, and expectations. The wealth impact means real economy depends on financial price movements and this same statement means that financial price movements create expectations on the future path of the real economy. This fact, that prices themselves are a cause as well as an effect of earnings movements, means that all the information is not contained in fundamentals.
Now it’s time to recall that the thing that drives investing in markets is profit and this basically means the prospect to sell at a higher price in the future. Dividend return has been at an average of 2% for the last 20 years: that is just to compensate for inflation. A lot of companies don’t pay dividends at all. The goal being to sell higher, the question a rational investor should ask himself is what securities will investors be preferring until some time in the future. So the real question is not what company has better fundamentals than another but which one is going to be preferred by investors. Now this means uncertainty and this is how we arrive at conventions.
When there is uncertainty people tend to introduce social agreements that help them clear their way. An example is people walking inside underground tunnels to change metro lines. Continuous prospects to hit somebody makes them organize and walk on one side of the tunnel (right side in France), even though there’s no regulation about it. Likewise in financial markets, people who manage to agree as a large group, succeed at correctly timing the market. Synchronization is key and conventions are there to synchronize -knowingly or unknowingly – the rational traders. Irrational ones are not aware of the existence of such conventions, so they keep hitting into bad investment returns.
One example of a financial convention is a Head and Shoulders pattern. This is a wonderful means for investors around the world to synchronize. Conventions may likewise be hiding everywhere, even in fundamental analysis (for example when one single formula enables a large number of market participants to coordinate their actions). It doesn’t mean that fundamental or technical analysis (as well as other disciplines we’ll look into) are all just about convention theory. But I suspect creating conventions is one important role they play.
The theory is not well known in the economic community although the more famous notions of self fulfilling prophecy, reflexivity, herding, feedback loop, sunspot and Keynes’s beauty contest, are closely related to it. The lack in some of these concepts of the idea that coordination is a goal justifies keeping the distinction.
I learned about conventions theory from the French author André Orléan, who is the most notorious economist having worked on the concept. He first (or maybe only after Keynes) understood that the already existent in sociology conventions theory was very suitable for explaining how financial markets work. He has spoken about this blog’s main idea so I strongly recommend his work. I will contribute with what I think are good examples of financial conventions and with my personal analysis.
A separate column will also discuss other economic topics I find interesting.