This is Part II of the series "Robert Prechter Dispels 10 Popular Investment Myths," where EWI president explains why traditional financial models failed in the 2007-2009 financial crisis -- and why are they doomed to fail again (and again). (Excerpted from Prechter's February and March 2010 Elliott Wave Theorists.)
You can read Part I here; come back later this week for Part III.
The Socionomic Theory of Finance
The Conventional Error of Exogenous Cause and Rational Reaction
By Robert Prechter
Refuting Exogenous Causality
The Efficient Market Hypothesis argues that as new information enters the marketplace, investors revalue stocks accordingly. If this were true, then the stock market averages would look something like the illustration shown in Figure 2. In such a world, the market would fluctuate narrowly around equilibrium as minor bits of news about individual companies mostly canceled each other out. Then important events, which would affect the valuation of the market as a whole, would serve as "shocks" causing investors to adjust prices to a new level, reflecting that new information. One would see these reactions in real time, and investigators of market history would face no difficulties in identifying precisely what new information caused the change in prices.
Figure 2:
Our idealized example shows what, under this model, would be the effects of a sudden slew of bad earnings reports, an unexpected terrorist attack with implications for many more to come, a large government "economic stimulus" program, a major contraction in GDP, a government program to bail out at-risk banks, a declaration of peace after a time of war and a significant decline in interest rates. Surely such events would -- rationally and objectively -- effect a change in stock prices, at least temporarily.
This is a simple idea and simple to test. But almost no one ever bothers to test it.
According to the mindset of conventional economists, no one needs to test it; it just feels right; it must be right. It's the only model anyone can think of. But socionomists have tested this idea multiple ways. And the result is not pretty for the theories that rely upon it.
The tests that we will examine are not rigorous or statistical. Our time and resources are limited. But in refuting a theory, extreme rigor is unnecessary. If someone says, "All leaves are green," all one need do is show him a red one to refute the claim. I hope when we are done with our brief survey, you will see that the ubiquitous claim we challenge is more akin to economists saying "All leaves are made of iron." We will be unable to find a single example from nature that fits.
Testing Exogenous-Cause Relationships from Economic EventsClaim #1: "Interest rates drive stock prices."
This is a no-brainer, right? Economic theory holds that bonds compete with stocks for investment funds. The higher the income that investors can get from safe bonds, the less attractive is a set rate of dividend payout from stocks; conversely, the less income that investors can get from safe bonds, the more attractive is a set rate of dividend payout from stocks. A statement of this construction appears to be sensible.
And it would be, if it were made in the field of economics. For example, "Rising prices for beef make chicken a more attractive purchase." This statement is simple and true. But in the field of finance such statements fly directly in the face of the evidence. Figure 3 shows a history of the four biggest stock market declines of the past hundred years. They display routs of 54% to 89%.
Figure 3:
In all these cases, interest rates fell, and in two of those cases they went all the way to zero! In those cases, investors should have traded all their bonds for stocks. But they didn't; instead, they sold stocks and bought bonds. What is it about the value of dividends that investors fail to understand? Don't they get it?
As in most arguments from exogenous cause (an observation made, as far as I know, for the first time in The Wave Principle of Human Social Behavior), one can argue just as effectively the opposite side of the claim. It is just as easy to sound rational and objective when saying this: "When an economy implodes, corporate values fall, depressing the stock market. At the same time, demand for loans falls, depressing interest rates. In other words, when the economy contracts, both of these trends move down together. Conversely, when the economy expands, both of these trends move up together. This thesis explains why interest rates and stock prices go in the same direction." See? Just as rational and sensible. On this basis, suddenly the examples in Figure 3 are explained. And so are the examples in Figure 4. Right?
Figure 4:
No, they're not, because, as the first version of the claim would have it, there in fact have been plenty of times when the stock prices rose and interest rates fell. This was true, for example, from 1984 to 1987, when stock prices more than doubled. And there have been plenty of times when stock prices fell and interest rates rose, as in 1973-1974 when stock prices were cut nearly in half. Figures 5 and 6 show examples.
Figure 5:
Figure 6:
So you can't take the equally sensible opposite exogenous-cause argument as valid, either. And you certainly cannot accept both of them at the same time, because they are contradictory.
At this point, conventional theorists might try formulating a complex web of interrelationships to explain these changing, contradictory correlations. But I have yet to read that any such approach has given any economist an edge in forecasting interest rates, stock prices or the relationship between them.
To conclude, sensible-sounding statements about utility-maximizing behavior (per the first explanation) and about mechanical relationships in finance (per the second explanation) fail to capture what is going on. Events and conditions do not make investors behave in any particular way that can be identified. Economists who assert a relationship (1) believe in their bedrock theory and (2) never check the data.
www.elliotwave.com
No comments:
Post a Comment