How Stories Drive the Stock Market

It is often said that markets are emotional. There is even discussion in the popular press about 'market psychology.' But until the advent of behavioral psychology it was often difficult to link the wisdom engendered by the influence of passions and feelings with the beliefs of the hard number purists who insist that anything anyone could ever want to know about economic performance is captured in the net present value of future cash flows.

While the audited financial statements still provide an often useful baseline, the era of big data has taught us that there are more nuanced factors at work - literally and figuratively - and that discerning the meaning of those figures especially in a period where high speed algorithmic decision-making holds sway, may provide investors, managers and individuals with knowledge that could make the difference between success and its less pleasant alternative. JL

Robert Shiller comments in the New York Times:

Narrative psychology suggests that popular narratives, particularly human interest stories, are fundamental drivers of motivation. Such feelings have real effects. The year 2000 was celebrated as the start of a new millennium. It seems to be no coincidence that the highest price-earnings ratio since 1881 occurred then. The recent fracking revolution had an effect on the whole stock market. Americans become emotional about that history of innovation.

Since the stock market began falling at the beginning of this year, there seems to have been a palpable change in the stories we have been hearing. Suddenly there is more willingness to entertain the possibility of a major stock market correction, or of an economic recession.It is no surprise that this kind of talk appears after a market drop: The stock market is perhaps the most famous leading indicator of a recession, though hardly a perfect one. That status has been well known at least since the 1920s.

Narrative psychology, as in the work of the New York University psychologist Jerome Bruner, for example, suggests that popular narratives, particularly human interest stories, are fundamental drivers of motivation. Several such narratives are worth looking at more closely.

One tale that has been intensified lately has focused on the Chinese economy and its stock market, including sharp market declines at the beginning of 2016. Long-abiding concerns about Chinese overinvestment, shadow banking issues, ghost cities that were built but never inhabited and similar problems have been amplified. In the West the narrative has been colored with emotions. China’s mistakes have been contrasted with Western optimism, our sense of patriotism and our sense of competitiveness.The prevalence of such stories encourages a gross exaggeration of the importance of the Chinese economy for our markets. Consider that United States exports in goods to China have recently accounted for only six-tenths of 1 percent of our gross domestic product. (United States imports in goods from China, though about four times bigger, are still relatively small as an overall proportion.) But once story-based thinking gets started, there is comparatively little public interest in such numbers.

Another current focus is the fact that this year set a record for poor performance of the stock market in the first week of the year. That timing has given the market-decline story wings, though there is really nothing special about such timing. After all, the date of the new year is an arbitrary social convention. There’s a Western Christian New Year, an Orthodox New Year, a Jewish New Year, an Islamic New Year, a Chinese New Year and so forth. The prominence of the Western year in global calendars reflects a history of Western dominance, and that has given the new year the ability to spark stories that evoke mixed, and changing, feelings.

Advertisement

Continue reading the main story

Such feelings have real effects. It is worth recalling the stock market movements at the beginning of the year 2000, which was widely celebrated as the start of a new millennium. That timing sounds portentous, but it is again completely arbitrary. Even using the Western calendar, the true millennium, it can be argued, was Jan. 1, 2001, but no matter. Jan. 1, 2000, was when the big party started for most people. And it seems to be no coincidence that the highest price-earnings ratio since 1881 (I calculate this ratio with 10-year-average earnings in the denominator) occurred around then. The Dow Jones industrial average had a record peak on Jan. 14, 2000, and then fell sharply.

A third narrative that is being widely conveyed concerns oil, and the extremely low prices that energy commodities have reached.

Just a few years ago the prevailing narrative about oil was all about the amazing United States success with a newly improved extraction method, fracking, to the detriment of the less creative oil-exporting countries. That story has been resonant here in America, where it has been taken as a tale of peculiarly American creativity. The history of modern petroleum may be seen as an American story that goes back to 1859 and Edwin Drake, who showed the world how it was possible, in Titusville, Pa., to drive a pipe deep through bedrock to reach oil. Drake became part of a great social narrative, leading the way to an entrepreneurial revolution in oil production and to still enduring American pride.

The recent fracking revolution — the United States has emerged as one of the world’s top oil producers in just the last few years — and the continuing story of American creativity has had an effect on the whole stock market. Americans can easily become emotional about that history of innovation.

Unfortunately, the bottom has just dropped out of that narrative, and some of us have gotten emotional about that, too. With this year’s extremely low oil prices, many of these frackers, so recently hailed as heroes, are going out of business. Their very ingenuity in increasing the supply of oil has been part of the problem by contributing to the oil price drop. It is easy to jump from this to broader conclusions: Maybe we’re not so smart after all, or so the new story goes. This thinking is a downer: Sometimes social narratives are quite depressing.

There is also a fourth story, a tale of the tripling of the United States stock market from 2009 to 2014 and its supposed sudden unwinding this year. This is not just a story about numbers: It too is a human interest story, one in which many investors missed a huge profit opportunity. They missed it because they overreacted to the 2008 financial crisis and became too fearful to stay in the market. This tale focuses on the success of market believers, who were wonderfully rewarded for their prescience. As I pointed out in a column in August, the popularity of this narrative led to a situation in which many people became aware that the market has gone up enormously, and it has most likely heightened sensitivity to the possibility of human fallibility and of correction now that the market has been dropping.

Most economists generally do not refer to such popular stories or assess their emotional appeal. The same is true for most historians, but the Yale historian Ramsay MacMullen is something of an exception. In his remarkable book, “Feelings in History: Ancient and Modern” (Regina Books, 2003), he wrote: “History is feeling. It is feelings that make us do what we do; and feelings can in fact be read. But the reading of them requires writers and readers to join their minds in ways that have long been out of fashion among students of history.”

Professor MacMullen tries to convey to the reader the feelings people had long ago when they were inspired or dejected. He says he believes this will help us understand history at a deeper level. One emotional story loaded with moral value leads to another, in his retelling. As an example, he gives us the tale of the murder of the abolitionist editor Elijah Lovejoy by a pro-slavery mob in 1837. That story motivated John Brown, helping to lead years later to his revolt and capture and hanging in 1859. And those events created another widely recounted emotional story that helped to lead to the Civil War and, eventually, abolition. Such popular stories are serious matters. They can lead to revolutions, or to market collapses.

Those who care about the stock market will surely be living through a new sequence of stories this year, including the four that I have enumerated here. Whether these narratives have a cascading effect, leading to further price decreases and yet more negative stories, is one possibility. But only time will tell us how the stories go.