With no read-through to the economic impact the virus is having (or will continue to have) on businesses, many economists have turned to becoming armchair epidemiologists. They are spending their time on the molecularity biology of the virus, on the infection curve, and comparing weather patterns of hard-hit areas. These are all import topics and it’s a serious time in both our country and the globe. However, drawing a line from the virus to the financial system is one fraught with risk and a steep hill to climb with many hidden traps.
See, we are not a civilization that’s overly fond of rationality. Hundreds (I’m guessing, I know of at least several great ones) of books have been written on this topic. Nobel Prizes have been awarded on this topic. Yet, ironically we continue to believe the actors involved in the markets and our consumer-based economy will act rationally. In 1978 Michael Jensen wrote that nothing had more evidence support than the efficient market hypothesis (EMH). The market has spent the last 42 years repeatedly saying “hold my beer” – finding unique and creative ways to prove EMH wrong. First, we had Black Monday, the dot-com bubble, the housing bubble, the 2010 Flash Crash, and a global pandemic is the latest trick up Mr. Markets sleeve to show those over-confident practitioners just how rational the public and the market is.
John Maynard Kenynes, regardless of your personal feelings of his politics or suggested policies, is considered one of the “greats” when it comes to economics. In 1936, Keynes wrote of an analogy comparing the stock market to a beauty contest conducted in a newspaper. To win you needed to not correctly guess the most beautiful woman in the contest but to guess who the other participants would think is the most beautiful.
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole: so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.
The General Theory of Employment, Interest and Money
Richard Thaler said, “Keynes’s beauty-contest analogy remains an apt description of how financial markets work.” The winner would not be an expert in facial symmetry but in understanding the actions and irrationality of crowds.
Today’s beauty contest is less attractive and has taken the form of a contagious virus. Its market implications are less known but the market’s actors involved have been, are, and will forever be irrational in the actions they take in response to the virus – whether overblown or under-reacted. In my opinion, it’s not important whether we are over-reacted or not, what’s important is the reaction and the continued reaction each passing day. Focusing solely on the virus is like looking at beauty contestant’s cheek bones while everyone else is making their bets on the color of their eyes, you may be right, but it won’t matter in the end.
The most recent example of this? Yesterday jobless claims rose to a multi-decade high of 3.28 million on the back of a practical nationwide quarantine of workers. What did the market do? Rip 6% higher! The stock market is not the economy and trying to connect them on the short-term in my opinion is a fool’s errand.
It’s our job as investors and financial professionals to not make judgement about the infection chart – not to guess the most beautiful woman in Keynes contest – but to evaluate how the market is responding, through supply & demand of stocks, bonds, currencies, and commodities.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.
