How not to write about stock markets

Ha-Joon Chang's claim that stock markets are "heading for trouble" depresses me. I had hoped that stock market punditry had moved beyond some guy's opinion.

What I mean is that a sensible view on the prospects for markets can take one of two forms - and I confess to being ambivalent between them.

The first one is that markets are complex emergent processes which are inherently impossible to predict. On this view, we just can't say where they're heading. All we can do is have a vague idea of expected returns and the standard deviation around them.

In this context, Chang misses the point here:

No one is offering a new narrative justifying the new bubbles because, well, there isn't any plausible story.

Such narratives are not only impossible - we can't foresee the future - but pernicious, because they give a false sense of security. All you need to justify the current level of share prices is a basic  bit of economic theory - that risky assets must offer higher expected returns than safe ones, so equities should be expected to rise. Granted, this theory is questionable. But Chang doesn't question it.

The second line of attack is to look for evidence of predictability in returns. My favourite indicator here is foreign buying of US equities*. When this is high, it's a sign that global investors are irrationally exuberant and so shares are heading for a fall. Last year, though, foreigners were net sellers, which points to good returns this year.

Again, though, Chang presents no evidence here. In fact, he ducks a chance to present some. He says:

Share prices are high mainly because of the huge amount of money sloshing around thanks to quantitative easing.

However, the Fed is only likely to withdraw QE if the economic outlook improves, which poses the question: could it be that the stock market will gain more from better growth than it loses from less loose monetary policy? I've suggested that the answer is: yes. Please, show me evidence I might be wrong - because Chang doesn't.

Now, I don't say this to say stock markets will definitely rise - as if anyone gives a toss about my opinion. In fact, I guarantee that they'll fall some time.

Instead, my point is that discussions of the market should be scientific: is there evidence of predictability or not? What they should not be is just some guy's judgement. This is especially true because we know that such judgments are prone to countless cognitive biases. I fear that one here is wishful thinking. The left wants to believe that finance will get its comeuppance, and the wish generates the belief. But we can, and should, try to do better than this.    

* The regression equation in my chart is: annual change in All-share index = 20.72 - 0.188 x foreign buying of US equities, $bn in the previous 12 months. R-squared = 45% since Jan 1996, standard error = 12pp. And no, this is not just in-sample fitting.

Comments

[Luis Enrique]

he also concludes "we" are heading for trouble, without really explaining why "we" should be much bothered by falling (or flat) share prices.

it would also have been nice if, instead of referring to QE money sloshing around, he'd have explained how if macro policy deliberately pushes returns on bonds down, you'd expect returns on other asset classes to fall too - so higher share prices now combined with lower future share price appreciation is a natural thing to expect, rather than some looming disaster.

a small question that occurred to me whilst reading that piece - what do share buy backs do to stock market indices? By analogy, suppose the FTSE100 was one company and the index is its share price, then its market cap depends on number of shares outstanding. Is the FTSE100 index more like a share price or a market cap?

[Chris Purnell]

As the FTSE hit an all time high 14 years ago surely to reach 'an all time high' in 2014 it would need to be circa 9500? If that is the case then we are far from 'bubble' territory.

[Ralph Musgrave]

Chris, You as for “evidence” that the stock market won’t “gain more from better growth than it loses from less loose monetary policy”. My “evidence” is as follows.

Attempts have been made to boost the US and UK economies by the ridiculous QE route: i.e. printing money and buying privately owned assets. That’s bound to raise the price of those assets by more (for a given rise in GDP) than would occur by a more rational method of boosting GDP (e.g. boosting household spending and/or public spending).

[Ivan Petkov]

Predicting markets is really easy –post factum. All the journalist are doing it.

[Andy]

All said and done you and Ha-Joon are my two favourite economists out there :-) Wish he'd write a blog as though provoking and intellectually stimulating as yours. And wish you'd write a book, something along the lines of "23 ways Marx explains all that is wrong in the world today" :-)

[pablopatito]

"stock markets are heading for trouble"

Aren't all stock markets (like Arsenal) "heading for trouble". Isn't that the nature of markets? It's just a question of predicting exactly when that's the tricky part. Ha-Joon Chang doesn't give any dates.

[Andrew]

Nice graph!

[cjcjc]

As Worstall points out, his linking of the FTSE (80% non-UK sales) and the S&P (50% non-US sales) with the UK and US economies is also...misleading shall we say.

He is an embarrassment to Cambridge economics.