Beware those who hear voices

This is my regular weekly Perspective column for Fund Strategy magazine.

You have no doubt seen or heard it many times. A financial pundit appears on a breakfast news programme after several days of market turmoil. “What are markets telling us in this morning’s trading?”, asks the presenter. The self-proclaimed expert, like an ancient oracle, then sagely interprets what the latest market gyrations mean.

Such scenes have become so common they are rarely questioned. Few express doubts about whether such readings of markets are useful let alone meaningful. It is far from clear that long-term market trends say anything about the economy.

Reading deep significance into what is sometimes literally a few minutes of trading is completely absurd. How can one individual distil what myriad market participants are saying in such a short time?

A crude but common assumption behind this search for meaning in financial volatility is that markets are more or less conscious. From this perspective those with the necessary experience and insight can read the market runes. Although many experts would deny making such an assumption they often act as if it is their premise.

This is a peculiar starting point because the main virtue of capitalism for many of its most ardent supporters is precisely that markets are unconscious. There is no individual or group of people in control.

Indeed, a consciously controlled economy is precisely what the most avid supporters of the market fear and detest: socialism. Even if socialists meant well, market advocates argue, a planned economy could only end in disaster. Modern economies are too big and complex to be directed by anyone.

A more sophisticated justification for reading meaning into markets is what has become known as the efficient markets hypothesis. The “efficiency” in this phrase refers to the processing of information. Markets are, in this view, mechanisms for agglomerating many individual desires to produce the best possible outcome for society as a whole. Capitalism may not be perfect but, so the argument goes, markets have produced far more prosperity than any alternative could.

A key problem with this model, at least in relation to financial markets, is that they can be extremely volatile. Asset markets can be strongly up one day and down the next without any substantial change in circumstances.

Defenders of market efficiency typically explain such violent fluctuations by arguing that markets overshoot on the downside and the upside. But such a claim calls into question the act of reading so much deep meaning into market movements. If the markets are constantly overshooting then perhaps short-term movements are not that significant after all.

In addition, it is worth noting that much more attention is given to falls rather than rises. It is not easy to see why a fall should be any more significant than an equivalent rise.

Perhaps the most fundamental misconception of all is that the movement of financial markets says something useful about the economy. It would be far better if it was recognised and acknowledged that the two are fundamentally different beasts. Strong asset prices do not signal a vibrant economy nor do falling prices necessarily indicate a weak one.

Research into long-term stockmarket returns by academics at London Business School showed no positive correlation between economic growth and equity returns.

Although such a connection is claimed, or at least implied, in numerous fund manager pitches, it does not withstand scrutiny. If anything, the authors argue, there may be a slight negative correlation between equity returns and economic growth.

If investing was such a straightforward matter it would simply be a question of investing in the strongest performing economies. Anyone who invested in China over the past few years, let alone the last three decades, would have made a killing. But in reality Chinese stockmarket returns have been extremely volatile and not particularly lucrative. At the time of writing the Shanghai Composite is at just over 40% of its October 2007 peak despite several years of strong economic growth in the interim.

This observation reinforces the point that those putting money into stockmarkets, let alone individual companies, are not investing in economies as such. They are investing in a bundle of firms, many of which may have overseas connections, which are subject to many forces, including speculative ones.

Even investments in government bonds are not straightforward investments into the economy as a whole. There are many other elements to a national economy besides the government’s balance sheet.

Short-term variations in supply and demand can also move bonds well away from what might be considered their fundamental value.

Those who want to know how pundits discern what markets are ostensibly saying should ask themselves one question. When do the talking heads ever disagree with the alleged verdict of the market? The supposed opinion of the market almost invariably coincides, by a strange coincidence, with the viewpoint of the expert.

It may be conscious or it may not but when pundits claim to be discerning the market’s opinions they are almost certainly giving their own views.

Individuals are entitled to promote their own opinions but it would be ­better if they acknowledged them as such. They should be able to substantiate their arguments on their own merits rather than claiming to have the validation of financial markets.

It is always best to be wary of those who say they hear voices inside their head.*

[* For some reason the final sentence was omitted from the version of the article published in the magazine].