The US stock indices are climbing to all time highs, with the Dow Jones punching towards 19,000. It’s an event that is not monocausal. It’s a complicated story. Which is the point. It’s a story. Because financial markets are stories about economic fundamentals.
Professor David Tuckett is a psychoanalysis at University College London. He has devoted a considerable portion of his career to studying how emotions effect market prices. He argues that most economists underemphasise the critical component of human psychology in financial markets. In general terms, there are two primal emotions that drive markets up and down. Excitement about gains and fear about loses. But it goes further.
The world is so complicated that it can never be fully understood. Which is a scary thought if dwelled upon. Information ambiguity. Which bits of information to pay attention to and which bits to just ignore. Finding the signal in the noise. Beyond being confusing and daunting it's actually so emotionally stressful that participants need to create a narrative thread, something that strings different pieces of information together, in order to take any kind of action. If they don't create stories then they will be acting on pure emotion. Excitement or fear.
If the available information includes falling Iron Ore prices market participants might begin to formulate a story where the Chinese economy is slowing down. If the Google Pixel smartphone is expected to become a growing hit a story where the future price of Coltan increases becomes believable.
Although based of economic fundamentals, stories about market prices are just that, just stories. Sometimes they are accurate and sometimes they are not. This is why financial markets are far more unstable than the economic fundamentals. The underlying fundamentals don’t change that quickly but the stories about them can totally change in just one afternoon.
Uber rich fund manager and philosopher George Soros talks about something that he calls ‘reflexivity.’ Reflexivity is an economic theory as well as a social theory. It refers to a circular relationship between cause and effect. A reflexive relationship is bidirectional with both cause and the effect affecting one another in a relationship is which neither can be assigned as causes or effects. It’s confusing but it is real.
Basically, and to give an example, if the story is that property prices in a Sydney are going to go up because that’s 'just what always happens' to real estate values in Australia’s biggest cities, then that story first causes the prices to go up. Those new higher prices then forms part of the new story that pushes prices higher again. It acts almost like a self-fulfilling prophecy. The new increased prices reinforce the original story that prices go up and create an even stronger story that prices will keep going up. It's a reinforcing loop. All the while, the economic fundamentals that should cause property valuations to increase are not ringing true.
At their core, financial markets are really just unstable information. Market participants arbitrate what the stories are at the moment. Whatever stories the market as a whole is adopting at any given moment will be reflected in the price. It's a never ending story but right now tale is that the US stock market is going up. It’s a compelling narrative. But like all great sagas, at some point there will be a twist.