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  • So GDP is down, retail sales have fallen off a cliff, and unemployment is the worst it's

  • ever been, but the stock marketis 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 that 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, the 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-calledearly cyclestocks, 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 marketde-coupling,” 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 all 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?

  • There's a long tradition of using emotional phrases to describe the world of finance.

  • The Great Depression.

  • The Panic of 1837.

  • Tulip Mania.

  • Investors are often described asoptimisticandcheery,” orskittishandglum.”

  • Alan Greenspan famously warned about traders' “irrational exuberanceduring the dot

  • com bubble, and there's an old Wall Street saying thatfinancial markets are driven

  • by two 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 theefficient 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 beundervaluedorovervalued.”

  • Since all public information about a company is already reflected in its stock price, it's

  • impossible tobeat 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 ask 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 to Hot or Not) is that shrewd

  • contestants would not pick the faces they actually thought were the prettiest, or even

  • the faces that 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

  • “2/3rds Game.”

  • A bunch of contestants are asked to pick a number between 1 and 100.

  • The winning number is the one that is closest to 2/3rds of the average of all the numbers.

  • So if the 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 the

  • 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 people think other

  • people will be willing to spend.

  • Much like the 2/3rds game, this can cause a cascading effect of over- or undervaluation.

  • In the 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 two theoretical portfolios of

  • stocks: “WinnersandLosers.”

  • TheWinnersportfolio was made up of companies whose stock price had recently performed

  • exceptionally well, and theLosersportfolio was full of stocks that had recently performed

  • exceptionally poorly.

  • His theory was that these movements were fueled by investors being over-enthusiastic about

  • the winners and overly-pessimistic about the losers.

  • If he was right, then all these extreme prices would regress back to the mean, causing the

  • Losersportfolio 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 callherd behavior”--jumping on

  • and off bandwagons because everyone else is.

  • What Thaler had tested was a form ofvalue 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

  • Buffet.

  • And then, something happened that Thaler 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 gotuneasyat the same time.

  • How, wondered Thaler, could a stock's price be 25% lower than it was the day before and

  • yetboth 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 Thaler and other economists did convince the financial community that

  • there was some element of human irrationality at play and it could be a 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.

  • In a time of economic uncertainty, the stock market seems to be the one thing that's

  • going well, so no one wants to be left behind.

  • Whatever the cause of the de-coupling, 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 Thaler's 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 cents!

  • Thanks to our patrons for keeping Two Cents financially healthy.

  • Click the link in the description to become a Two Cents patron!

So GDP is down, retail sales have fallen off a cliff, and unemployment is the worst it's

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Is the Stock Market Irrational?

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