Robert Prechter Dispels 10 Popular Investment Myths, Part IV

The Socionomic Theory of Finance

The Conventional Error of Exogenous Cause and Rational Reaction

By Robert Prechter

Claim #3: "An expanding trade deficit is bad for a nation's economy and therefore bearish for stock prices."

Over the past 30 years, hundreds of articles -- you can find them on the web -- have featured comments from economists about the worrisome nature of the U.S. trade deficit. It seems to be a reasonable thing to worry about. But has it been correct to assume throughout this time that an expanding trade deficit impacts the economy negatively?

Figure 8 answers this question in the negative.

In fact, had these economists reversed their statements and expressed relief whenever the trade deficit began to expand and concern whenever it began to shrink, they would have accurately negotiated the ups and downs of the stock market and the economy over the past 35 years. The relationship, if there is one, is precisely the opposite of the one they believe is there. Over the span of these data, there in fact has been a positive -- not negative -- correlation between the stock market and the trade deficit.

So the popularly presumed effect on the economy is 100% wrong. Once again, economists who have asserted the usual causal relationship neglected to check the data.

It is no good saying, "Well, it will bring on a problem eventually." Anyone who can see the relationship shown in the data would be far more successful saying that once the trade deficit starts shrinking, it will bring on a problem. Whether or not you assume that these data indicate a causal relationship between economic health and the trade deficit, it is clear that the "reasonable" assumption upon which most economists have relied throughout this time is 100% wrong.

Around 1998, articles began quoting a minority of economists who -- probably after looking at a graph such as Figure 8 -- started arguing the opposite claim. Fitting all our examples so far, they were easily able to reverse the exogenous-cause argument and have it still sound sensible. It goes like this: In the past 30 years, when the U.S. economy has expanded, consumers have used their money and debt to purchase goods from overseas in greater quantity than foreigners were purchasing goods from U.S. producers. Prosperity brings more spending, and recession brings less. So a rising U.S. economy coincides with a rising trade deficit, and vice versa. Sounds reasonable!

But once again there is a subtle problem. If you examine the graph closely, you will see that peaks in the trade deficit preceded recessions in every case, sometimes by years, so one cannot blame recessions for a decline in the deficit. Something is still wrong with the conventional style of reasoning. ...

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READ MORE - Robert Prechter Dispels 10 Popular Investment Myths, Part IV

Robert Prechter Dispels 10 Popular Investment Myths, Part III

The Socionomic Theory of Finance

The Conventional Error of Exogenous Cause and Rational Reaction

By Robert Prechter

Claim #2: "Rising oil prices are bearish for stocks."

This is a ubiquitous claim. It would take weeks to collect all the statements that economists have made to the press to the effect that recently rising oil prices are "a concern" or that an unexpected (they're always unexpected) "oil price shock" would force them to change their bullish outlook for the economy.

For many economists, the underlying assumption about causality in such statements stems from the experience of 1973-1974, when stock prices went down as oil prices went up. That particular juxtaposition appeared to fit a sensible story of causation regarding oil prices and stock prices, to wit: Rising oil prices increase the cost of energy and therefore reduce corporate profits and consumers' spending power, thus putting drags on stock prices and the economy.

Figure 7 shows, however, that for the past 15 years there has been no consistent relationship between the trends of oil prices and stock prices.

Sometimes it is positive, and sometimes it is negative. In fact, during this period it has been positive for more time than it has been negative! And the quarters during this period when the economy contracted the most occurred during and after the oil price collapse of 2008. Thereafter oil prices doubled as the economy was reviving in 2009. None of this activity fits the accepted exogenous-cause argument.

But wait. Could rising oil prices perhaps be bullish for stocks? Yes, once again we can argue both sides of the exogenous-cause case. Consider: As the economy begins to expand, business picks up, so stock prices rise; and as business picks up, demand for energy rises as businesses gear up and operate at higher capacity. That's why stocks and oil go up together. Makes sense, doesn't it?

But neither claim explains the data. Sometimes oil and stocks go up or down together, and sometimes they trend in opposite directions. As with Figures 3-6 [see Part II -- Ed.], we could easily isolate examples of all four pairs of coincident trends. To conclude, we can determine no consistent relationship between the two price series, and no economist has proposed one that fits the data.

This graph negates all the comments from economists who say that an "oil shock" would hurt the stock market and the economy. It also throws into doubt the very idea that stock prices and oil prices are linked.

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READ MORE - Robert Prechter Dispels 10 Popular Investment Myths, Part III

Robert Prechter Dispels 10 Popular Investment Myths, Part II

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.

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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.

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READ MORE - Robert Prechter Dispels 10 Popular Investment Myths, Part II

Robert Prechter Dispels 10 Popular Investment Myths, Part I

You may remember that in 2008-2009, as the worst financial crisis since the Great Depression was ravaging stocks, real estate, commodities and other "can't lose" asset classes, many called into question traditional economic models -- because they did little to warn us of the approaching doomsday.

So, today, we are starting a new series: "Robert Prechter Dispels 10 Popular Investment Myths," where EWI president gives detailed explanation of why the traditional financial models failed -- and, very importantly, why they doomed to fail again (and again). (Excerpted from Prechter's February and March 2010 Elliott Wave Theorists.)

It's an important series. Read it carefully -- it will explain many "paradoxes" you see in financial markets daily and open your eyes to the shortcomings of modern economics. Here is Part I; come back next week for Part II.

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The Socionomic Theory of Finance

The Conventional Error of Exogenous Cause and Rational Reaction

By Robert Prechter

Every time there is a recession, observers grumble about economists' methods. The deeper the recession carries, the louder the grumbling. The reason that widespread complaints occur only in recessions is that economic forecasters as a group never, ever anticipate macroeconomic changes. Their tools don't work, but consumers of their commentary do not notice it until recessions occur, because that is the only time when everyone can see that the methods failed. The rest of the time, when expansion is the norm, no one notices or cares.

Ironically, in the long run, the complaints never stick. Once the economy begins expanding again, everyone forgets about their old complaints. The media resume quoting economists, despite their flawed methods, and they are once again satisfied that their commentaries make perfect sense. There is a good reason for this recurring behavior. At the end of this exposition, we will explore why it happens, over and over, and why it probably will never cease.

The recent/ongoing economic contraction is the deepest since the 1930s, so the complaints about economists' ideas are the most strident since that time. Figure 1 shows how one publication expressed this feeling following four quarters of negative GDP (and just before the recent partial recovery began).

The rebound in the economy since July [2009] has brought a collective sigh of relief from the economics profession. Yet the bankruptcy of conventional methods for predicting trends in the macro-economy has not gone away. Even in this cycle, it has only begun to manifest.

Economists polled by USA Today and The Wall Street Journal are back to normal, which is to say unanimously optimistic, for at least a full year ahead. When these optimistic forecasts fail yet again and the bear market and depression deepen, economists will find themselves even more on the defensive. Critics' complaints will become even louder. By the bottom, everyone will agree that economic theory is worthless. Then, in the recovery, everyone will go back to using it again.

Nevertheless, this brief time of doubt and criticism affords socionomics an opportunity to be heard. People listen only when they are emotionally attuned to alternative ideas, and we have such a time now. For over 30 years, I have argued that the socionomic model of social causality is not only beautiful and elegant but also true. A subset of socionomics, the socionomic theory of finance (STF), is consistent with empirics, and to the extent of our ability as theoreticians, internally consistent as well. Other theories of finance fail on one or both grounds. This series will provide an overview of STF so that you can judge these aspects for yourself.

Few people are able to find socionomic theory accessible until they first see that their old way of thinking is flawed. So we will begin with a look at the reigning ideas, which are based on mechanistic causality, to which most humans naturally default, even in the social realm.

The Fundamental Flaw in Conventional Financial and Macroeconomic Theory

Conventional financial theory relies upon the related and seemingly sensible -- indeed seemingly imperative -- ideas of exogenous cause and rational reaction. In a limited but comprehensive survey, we find that modern academic papers, studies, hypotheses and theories about social motivation -- in the fields of finance, economics, politics, history and sociology -- begin with these ideas, whether they are stated explicitly or not.

Most of the time, these ideas are stated explicitly. Papers are packed with discussions of and conjecture about "information flows," "exogenous shocks," "fundamentals," "input," "catalysts" and "triggers." Even hypotheses that make room for mass psychology embrace ideas such as "positive feedback loops" under the assumption that even if social mood were to turn on its own accord, resulting events have the power to reinforce social mood and, more narrowly in the realm of finance, to affect aggregate investors' buying and selling decisions. Papers on behavioral finance that describe non-rational behavior nevertheless treat it as an exception or departure from rationality, objectivity, utility maximization and market equilibrium, all of which are characteristic of the exogenous-cause/rational-reaction paradigm. This paradigm is accurate and useful in microeconomics but inaccurate and useless in fields of finance or so-called macroeconomics (which as I hope to show is really a subset of socionomics).

The Efficient Market Hypothesis (EMH) and its variants in academic financial modeling as well as the entire profession of applied economics rely at least implicitly but usually quite explicitly upon the bedrock ideas of exogenous cause and rational reaction. Stunningly, as far as I can determine, no evidence supports these premises, and, as the discussion below will show, all the evidence that we socionomists have investigated contradicts them.

Later in this exposition I hope to show that every proposed relationship that fails under an exogenous-cause explanation becomes a success when given a socionomic explanation.

(Next: Robert Prechter tests "Claim #1: 'Interest rates drive stock prices.'")

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READ MORE - Robert Prechter Dispels 10 Popular Investment Myths, Part I