Equity markets are fertile ground for speculation in the two meanings of the term: greed, and advancing theories or conjectures without firm evidence. There are two major hurdles to deriving a viable theory of the stock markets. The first is the large number of variables that can have an influence at both micro and macro levels. Borrowing from Donald Rumsfeld’s taxonomy, the relevant factors are a collection of “known unknowns” (interest rates, corporate profits, etc.) and “unknown unknowns” (wars, natural disasters, alien invasions, etc.)
But the greatest challenge is that equity markets are not just natural phenomena occurring in isolation from human minds, but inter-subjective abstract constructs instead, which emerge as a result of an anticipation game between a large (and growing) number of participants. As a consequence, markets have the ability to memorize, learn and adapt; in a similar way as the artistic canon evolves over time, making it difficult to predict its next twist.
Thus any prospective theory of financial markets requires a combination of data as well as a plausible narrative of human behavior, making historians as apt for the endeavor as economists. Unfortunately, the field is also a magnet for charlatans and fortune tellers, who can prosper in the wake of complexity, in a similar way to astrology. In fact, market gurus and horoscope writers have a lot in common; both aim to be as vague and as unpredictive as possible, whilst leaving a number of escape routes open in the event of overwhelming disconfirming evidence. On the one hand they resort to the zodiac sign’s “ascendant”, on the other, to market “timing”.
You can find speculative theories of every kind. Animalistic, associating market trends with bulls and bears; anthropomorphic, which speak of markets that have “head and shoulders” and “sentiments” ranging from euphoria to panic; and lastly, there are theories of a superstitious nature, like the “Dow” and “Odd-Lots” theories, which rely on numerology, astrology’s kin in mathematics.
These days, a very popular proposition is the “Buy the Dips” hypothesis. Its rationale is as follows: equity markets trend upwards over the long-run. Hence, every market correction offers a good entry point to take a ride to infinity and beyond. The thesis is deceivingly solid for two reasons. Firstly, it is the case that equity markets are propelled by a short of inverse gravity pull, as listed companies need to provide a positive return on capital in order to survive. In fact, if the growth rate of corporate earnings is higher than the cost of equity, the intrinsic value of a stock would tend to infinity, thus every price you pay is cheap. Moreover, the theory cannot be falsified in a Popperian sense, as in those cases when it seems not to work – Japan’s Nikkei trading at 50% of its 1989 peak being the most prominent example – it can always be argued that it is just a matter of time until the market surpasses its previous peak.
With central banks flushing markets with liquidity and depressing bond yields as a result, this theory is helping to lure reluctant investors into the equity markets. However, anyone buying at current levels should be wary of falling victim to another popular antagonistic theory, and end playing the character of the “Greater Fool”, who is the last investor to buy at an inflated price.
Fernando de Frutos, MWM Chief Investment Officer
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