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Are Markets Rational? PDF E-mail
Written by Marcus Killick   
Thursday, 13 November 2008 00:00
As the global economy continues to slide, the list of culprits grows; banks, regulators, governments, short sellers, all have taken their turn in the firing line.  Maybe they are all guilty, but I do feel that years of buying what we can’t afford and spending what we don’t have might have a small amount to do with it.

Similarly, the massive gyrations in the world’s stock exchanges have caused people to question whether these markets are behaving in a rational way or whether the market’s behaviour itself is contributing to, rather than simply being a symptom of, the current crisis.

I admit that there is something intrinsically wrong in ascribing a mood or a state of mind to an inanimate object. No one ever refers to a “happy” rock or a “depressed” chair.  Yet the financial world treats the market as if it is a living entity. It is not; its behaviour is the result of the interaction of those within it. However, the result of this is that the market can have certain “human” features attributed to it.

It is the interaction that is key, not the individual behaviours themselves. Just as the action of a member of an angry mob is often wholly different from the actions that person may take if alone, so the market, like the mob, appears to act as if alive.  So, if it appears to be alive, does it appear to be rational?

No doubt individual traders, fund managers and analysts are (in general) rational, sensible human beings. They may be driven by greed, the desire for success, by a passionate belief in capitalism; whatever. Their actions are designed to achieve that goal. However these actions are intertwined with the actions of others who may have different objectives. Therefore the market itself has no aims.

Given so many different objectives, some in conflict, some driven by short term aims others by long term, the market, whilst functional, is inherently unstable.

In my view, this means that the market can never be rational. It can act rationally, sometimes for considerable periods. However, eventually it will revert to an irrational state with reckless exuberance being inevitably followed by nemesis. In fact the market more closely resembles a person with Bipolar disorder (more commonly referred to as manic depression).

Bipolar disorder is an illness that affects thoughts, feelings, perceptions and behaviour. Most often, a person with manic-depression experiences moods that shift from high to low and back again in varying degrees of severity. The two poles of bipolar disorder are mania and depression. About 5.7 million American adults, or about 2.6 percent of the population aged 18 and older, have bipolar disorder.

When a person is going through the depression phase, symptoms include feeling hopeless, helpless or worthless for a sustained period of time and becoming unable to make simple decisions

The manic phase might include feeling like you can do anything, even something unsafe or illegal, spending money extravagantly, living recklessly, experiencing hallucinations or delusions and feeling filled with energy.

Some people believe they are "over their depression" when they become manic, and don't realize this state is part of the illness. As a result, some do not take the drugs prescribed or cease taking them as they are “over their illness”.

Manic depression is a serious condition both for the sufferer and those close to them. For some the symptoms are mild but for others it is more extreme, requiring drugs and psychiatric therapy.

The phases go in waves, sometimes mild and far apart, sometimes very close and extreme. At the extreme end, a manic depressive can turn from being the life and soul of a party to angry and aggressive in the space of minutes. At the mildest, the individual can go for months or years without an episode being triggered.  

In my view, the market has now moved from a long manic phase and is rapidly moving down the curve into a depressed state.

Until recently the market, indeed the economy, has appeared invincible.  It (or rather it participants) believed they had broken the economic cycle.  Products such as credit derivatives were created without regard for their intrinsic risk. Massive bonuses were paid on the back of short term share price increase, so encouraging risk and destabilising the market in the longer term for the benefit of the short term.  

Some, like Warren Buffet, did try and warn of the risks being taken and the dangers ahead, but the market/economy was having too much fun to listen. Others prescribed measures to at least curtail the worst excesses, but these were not taken (the market, after all, didn’t think it need them). Many others simply did not recognise the condition. They believed the mania was normal. Yet the longer it continued, the further the inevitable fall would be.

It could not go on for ever but, as "Chuck" Prince, the now ex chief executive of Citigroup, said in 2007 “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Unfortunately no one can dance forever.

All it needed was a trigger to turn the mania into depression.

Then it came.

I have argued previously that you could identify several triggers. Maybe it was one of them, maybe it was the combination. With bipolar sufferers, it is sometimes as simple as too much alcohol at a party. Ultimately, this is one for the history books.

We are now inexorably moving towards the depressive phase. On the way we will see wild fluctuations. According to the economist, on October 13th the Dow’s brief climb of 936 points in a single day was more than it had achieved in the first 85 years of its existence.

So what happens next, and how long will this phase last before the market heads towards mania again?  Just as the manic phase can last for years, so can the depressive phase.  At the end of 1964 the Dow Jones Index stood at 874.1; by 1981 it was at 875. On the other hand, the episode may be brief.  During this time, the market will accept the remedies prescribed by governments and regulators (only to try and reject them once it moves back into mania).

If I am right, then the market will always move between these phases. There is no escaping it; like bipolar disorder, it is not curable but it is treatable.  We will therefore have to start dealing with the market in a different way. We must ensure we control its mood swings in future, both in mania and in depression. It will mean it will not be so much fun to be with in the good times but a lot easier to manage in the bad ones.
 
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