self GDP is down retail sales have
fallen off a cliff an unemployment is
the worst it's ever been but the stock
market is doing pretty good
what gives have all these traders been
living in a cave for the last three
months or maybe they're ahead of the
curve and they already know the economy
is on the mend that's a nice thought but
it's probably safer to stick to Paul
Krugman's three rules about interpreting
stock prices first stock market is not
the economy second the stock market is
not the economy third the stock market
is not the economy a lot of the rosy
numbers are being driven by big tech
companies like Amazon and Apple who are
doing gangbusters with everyone trapped
at home so-called early cycle stocks
which tend to be more reflective of the
real economy like cars banks and
consumer goods are lagging behind and
thousands of small businesses crippled
by the pandemic are not represented in
the stock market at all some economists
describe what's happening as a market
decoupling when stock prices cease to
reflect economic realities most
forecasters now predict a lot of bad
numbers in the coming months yet
investors are strangely optimistic the
warning lights are flashing red but the
market seems to be blissfully unaware of
the storm on the horizon if you're
thinking wait a minute I thought stock
traders were supposed to be really
logical people well you just waded into
a century long debate about the very
nature of the stock market is it a
rational mechanism that accurately
reflects what companies are worth or is
it governed by the touchy-feely emotions
and biases that all humans are subject
to
[Music]
there's a long tradition of using
emotional phrases to describe the world
of Finance the Great Depression the
panic of 1837 tulipmania
investors are often described as
optimistic and cheery more skittish and
glum Alan Greenspan famously warned
about traders irrational exuberance
during the dot-com bubble and there's an
old Wall Street saying that financial
markets are driven by too powerful
emotions greed and fear and yet for much
of the 20th century the consensus among
economists was that the market was
perfectly rational and stock prices were
always an accurate reflection of a
company's true value according to the
efficient market hypothesis investors
react to good or bad news about a
company driving the price up or down
until the risk is balanced with the
reward therefore in theory a company can
never be undervalued or overvalued
since all public information about a
company is already reflected at its
stock price it's impossible to beat the
market many years earlier John Maynard
Keynes one of the godfathers of modern
economics doubted that a dispersed pool
of investors could really know a
company's true value he compared the
stock market to an offensively outdated
little contest the British newspapers
would sometimes hold in the 1930s they
would print the photos of a hundred
women and asked the readers to pick the
six prettiest faces the winner would be
the person whose choices most closely
matched the average choices of all the
contestants the problem with this aside
from it being an ancestor too hot or not
is that shrewd contestants would not
pick the faces they actually thought
were the prettiest or even the faces
they thought the average person would
find the prettiest but the faces that
they thought the average person would
guess the average person would find the
prettiest if you think your head is
spinning now consider another version of
this dilemma called the 2/3 game a bunch
of contestants are asked to pick a
number
between one and 100 the winning number
is the one that is closest to two-thirds
of the average of all the numbers so if
average is 50 whoever picks 33 wins but
assuming most of the contestants can do
basic math they'll probably choose 33
which means the winning number is now 22
and if most of the contestants
anticipate this they'll likely choose 22
making human winning number 15 and if
they all guess that the others are
thinking the same way they'll choose 15
and the winning number is now 10
depending on how clever the group is the
winning number can quickly dwindle down
to zero
these examples are meant to illustrate
that when people buy and sell stocks
they're not always trying to predict
something as concrete as profitability
many speculative traders are simply
trying to guess what other people will
be willing to spend on a stock in the
future which is dependent on what those
other people think other people will be
willing to spend much like the
two-thirds gain this can cause a
cascading effect of over or under
valuation in 1980s the Nobel
prize-winning economist Richard Thaler
set out to prove that it was possible
for companies to be over or undervalued
by building to theoretical portfolios of
stocks winners and losers the winners
portfolio was made up of companies whose
stock price had recently performed
exceptionally well and the losers
portfolio was full of stocks that had
recently performed exceptionally poorly
his theory was that these movements were
being fueled by investors being over
enthusiastic about the winners and
overly pessimistic about the losers if
he was right then all of these extreme
prices would regress back to the mean
causing the losers portfolio to perform
better and that's exactly what happened
in survey after survey the losers
performed better than the winners often
by a wide margin it seemed to suggest
that stock prices can be influenced by
what Keynes called investors animal
spirits or what psychologists might call
herd behavior jumping on and off
bandwagons because every
one else's what failure had tested was a
form of value investing betting that
certain companies are being undervalued
by the market the efficient market
hypothesis said this should be
impossible but tell that to Warren
Buffett and then something happened that
Baylor believed settled the debate good
evening today is Black Monday the day
the dow dropped more than 500 points
Black Monday on October 19th 1987 stock
prices crashed all over the world
without warning or explanation according
to the efficient market hypothesis stock
prices are only supposed to change based
on new information and yet there was
little to precipitate the crash
other than that investors all got uneasy
at the same time how wondered Thaler
could a stock's price be 25% lower than
it was the day before and yet both be
rational measures of intrinsic value
given the absence of news this is not to
say that the stock market is pure
fantasy quarterly reports and profit
margins do matter and you can't have a
high share price for long without
something real to back it up but the
work of failure and other economists did
convince the financial community that
there was some element of human
irrationality at play and it could be
the cause of market volatility so where
does that leave us today no one knows
for sure why the stock market is doing
well during an economic crisis but there
are some theories for one the federal
government has been pouring billions of
dollars into the economy and that kind
of sudden liquidity can be like a shot
of adrenaline even if the underlying
economy is weak a second theory is that
there's nowhere else for the money to go
bonds currently have very low even
negative returns so investors have no
choice but to focus on stocks and with
sports and casinos closed even gamblers
are turning to the stock market as an
alternate table to place their bets and
then there's good old-fashioned FOMO at
a time of economic uncertainty the stock
market seems to be the one
that's going well so no one wants to be
left behind
whatever the cause of the decoupling
many experts warn that it probably won't
last forever a new round of bad economic
numbers or the Fed turning off the
spigot might pull it back down to earth
does that mean you should get out not
necessarily people who hop in and out of
the stock market tend to lose money
compared to people who just sit tight
and wait it out Richard thalers best
piece of advice for investors is to
rarely check your portfolio and avoid
reading the news the stock market is not
an Oracle with all the answers nor a
casino where anything goes it's a tool
for growing your finances and like most
tools it's safest to handle when you're
calm and collected and that's our two
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