SYNOPSIS: Proposes a theory of 'catching up with the Joneses' to attack rational expectations for stocks.
The more I look at the amazing rise of the U.S. stock market, the more
I become convinced that we are looking at a mammoth psychological problem.
I don't mean mammoth as in "huge" (though maybe that too), but as in "elephant".
Let me explain.
If you follow trends in psychology, you know that Freud is out and Darwin
is in. The basic idea of "evolutionary psych" is that our brains are exquisitely
designed to help us cope with our environment - but unfortunately, the
environment they are designed for is the one we evolved and lived in for
the past two million years, not the alleged civilization we created just
a couple of centuries ago. We are, all of us, hunter-gatherers lost in
the big city. And therein, say the theorists, lie the roots of many of
our bad habits. Our craving for sweets evolved in a world without ice-cream;
our interest in gossip evolved in a world without tabloids; our emotional
response to music evolved in a world without Celine Dion. And we have investment
instincts designed for hunting mammoths, not capital gains.
Imagine the situation back in what ev-psych types call the Ancestral
Adaptive Environment. Suppose that two tribes - the Clan of the Cave Bear
and its neighbor, the Clan of the Cave Bull - live in close proximity,
but traditionally follow different hunting strategies. The Cave Bears tend
to hunt rabbits - a safe strategy, since you can pretty sure of finding
a rabbit every day, but one with a limited upside, since a rabbit is only
a rabbit. The Cave Bulls, on the other hand, go after mammoths - risky,
since you never know when or if you'll find one, but potentially very rewarding,
since mammoths are, well, mammoth.
Now suppose that it turns out that for the past year or two the Cave
Bulls have been doing very well - making a killing practically every week.
After this has gone on for a while, the natural instinct of the Cave Bears
is to feel jealous, and to try to share in the good fortune by starting
to act like Cave Bulls themselves. The reason this is a natural instinct,
of course, is that in the ancestral environment it was entirely appropriate.
The kinds of events that would produce a good run of mammoths - favorable
weather producing a good crop of grass, migration patterns bringing large
numbers of beasts into the district - tended to be persistent, so it was
a good idea to emulate whatever strategy had worked in the recent past.
But now transplant our tribes into the world of modern finance, and
- at least according to finance theory - those instincts aren't appropriate
at all. Efficient markets theory tells us that all the available information
about a company is supposed to be already built into its current price,
so that any future movement is inherently unpredictable - a random walk.
In particular, the fact that people have made big capital gains in the
past gives you absolutely no reason to think they will in the future. Rational
investors, according to the theory, should treat bygones as bygones: if
last year your neighbor made a lot of money in stocks while you unfortunately
stayed in cash, that's no reason to get into stocks now. But suppose that,
for whatever reason, the market goes up month after month; your MBA-honed
intellect may say "Gosh, those P/Es look pretty unreasonable", but your
prehistoric programming is shrieking "Me want mammoth meat!" - and those
instincts are hard to deny.
And those instincts can be self-reinforcing, at least for a while. After
all, whereas an increase in the number of people acting like Cave Bulls
tended to mean fewer mammoths per hunter, an increase in the number of
modern bulls tends to produce even bigger capital gains - as long as the
run lasts. Any broker can tell you that in the last few months the market
has been rising, despite mediocre earnings news, because of fresh purchases
by ever more people distraught about having missed out on previous gains
and desperate to get in on the action. Sooner or later the supply of such
people will run out; then what?
OK, OK, I know that this isn't supposed to happen. Sophisticated investors
are supposed to take the long view, and arbitrage away these boom-bust
cycles. And maybe, just maybe, the market is where it is because wise and
far-seeing people have understood that the New Economy can produce growing
profits forever, and that the rise of mutual funds has eliminated the need
for old-fashioned risk premia. But my sense is that people who try to take
a long view have been driven to the edge of extinction by the sheer scale
of recent gains, and that the supposed explanations you now hear of why
current prices make sense are rationalizations rather than serious theories.
The whole situation gives me the chills. It could be that I just don't get it, that I'm a Neanderthal too thick-skulled to understand the new era. But if you ask me, I'd say that there's an Ice Age just over the horizon.