The Mouse on the Market

Chairman Greenspan coined the phrase "irrational exuberance" to characterize the dot.com bubble that was inflating in the late 90s. So far as I know, the chairman never went so far as to assign the tag, "irrational," to the entire market. He seemed by his remark interested only in curbing the market’s upside excesses, content to let the downside seek its "proper" level without the aid of coaxing from on high ("on high" being his office). But that’s an exaggeration. It’s just that during the better part of Greenspan’s sentence as U. S. Central Banker the market was more exuberant than despairing. Toward the end of his time, when the economic cycle turned – as it always does – the “Fed” stood on its head to change the market’s direction. It had continuously raised interest rates during the “boom;” now it was just as assiduously lowering them. And sure enough, the market turned.

But let me suggest that, based upon observation of the real-world causes that lead the market to move, the Fed could have done nothing -- ever -- and the economy would have moved up and down around a midpoint just as it did anyhow. If they saw things getting irrationally exuberant, or irrationally despairing, instead of raising or lowering interest rates, they should have merely made an appropriate announcement, that either they were thinking about lowering or raising the rate, or some other emotion-packed statement designed to assuage investors’ fears or create them.

Why do I think that would work? Well you take what happened just this last Wednesday morning. The market had been dawdling along for a couple of weeks, trading “range-bound,” as us “professionals” say. The ups and downs were at the mercy of a narrow separation between the number of fearful and hopeful people. Hence, no real trend had taken hold. Ah, but on Wednesday morning, the government bureau in charge of creating hope and fear announced that the core inflation rate was 1/10th of one percent higher than had been predicted, 3/10ths instead of 2/10ths. This outrageously high inflation rate immediately took hold of the hearts and souls of millions of investors throughout the world, causing the fearful to become more fearful, the hopeful to become less hopeful . . . and in the course of the next few hours, the stocks trading on the major U. S. markets lost about $1,000,000,000,000 (a trillion dollars) of their value. (Maybe a shade more or less.)

Question: What caused the sell-off? Answer: A statistic., that is, one number, a “3” instead of a “2.”

Mark Twain once said, “Facts don’t lie, but statistics are more flexible.” But even if that statistic were correct, even if the cost of living went up 1/10 of a percent more than was anticipated, the market’s reaction was all out of proportion to the actual effect the number should have had on the market.

To understand better why such seemingly “irrational” behavior on the part of investors was actually not irrational in particular cases, consider that some of the millions of transactions that brought about the depreciation of market prices may have been rational. Many of those who sold their stocks for dollars, did so in anticipation of buying them back later for a lower price. Those wise enough – or fortunate enough – actually to benefit from the series of barters (stocks for dollars, dollars for stocks) were wholly rational. They knew they were taking a risk – that the market would not continue to slide – but did so because – and here’s the point -- they trusted that the rank and file of the people trading in the market would be led by the irrational shifting of their hopes and fears. They knew the market as a whole was irrational.

Actually, a better word would be neurotic. The American psychologist A. A. Brill defined neurosis as “a mild mental pathology in which the patient experiences more joy or sorrow from a situation than is really in it.” The market – meaning, the millions of people whose hopes and fears control the market – does not and cannot move in real time on the basis of real information relating to the value of the companies whose stocks they are trading. Even though information moves more rapidly today than ever before, it still cannot keep pace in everyone’s mind with the minute-by minute changes in the prices of stocks. The vast majority of stock market trades are not made on the basis of value (as in the worth of the companies); they are made on the basis of price, the information readily and immediately available to the fulltime market trader. True, the traders may possess an underlying knowledge of the value of the companies they trade, but their actions are, more often than not, based on price movements, rather than changes in value . . . and price movements are by-and-large “irrationally neurotic.”

In writing this an awareness presented itself to me that had not, before now, appeared. I’ll save that one for tomorrow. It’s a doozie.