Why It's Unworkable To Apply Economics Analysis In The Forum Of Finance

As we were having a discussion below regarding the fact that the economy and the market are not one and the same, here is a little bit of information to explain why:

The main issue that we must address is that it is unworkable to apply analysis of economics in the forum of finance.  In fact, it has been an abject failure at the times when it was most needed.

After the analyst community failed to foresee the market swoon off the 2000 market top, on October 6, 2002, Paul Samuelson, a co-founder of modern economics, admitted “[w]e are at a loss for words.  If nothing else, this baffling economy has defeated the vocabulary of economics.”  As an aside, it is interesting to note that Samuelson’s admission came within several days before the market bottomed and began a multi-year rally into 2007.    Yes, his exasperated admission wherein he effectively threw his hands up in the air in submission marked a multi-year bottom at an extreme in negative market sentiment.  He was being driven by market sentiment and likely did not even realize it.

But, the failures of 2000 have not stood alone.  While there were many admissions of failure after the analyst community’s inability to also recognize the impending market meltdown which began in 2007, I will list a few that were cited by Bob Prechter in The Socionomic Theory of Finance.  

In February of 2009, the Kiel Institute noted that “the global financial crisis has made clear a systemic failure of the economics profession.  In our hour of greatest need, societies around the world are left to grope in the dark without a theory . . . The corner stones of many models in finance and macroeconomics are rather maintained despite all the contradictory evidence discovered in the empirical research.” 

Also in February of 2009, Paul Volker, former Fed Chairman, said regarding the economy: “It’s broken down in the face of almost all expectation and prediction.   Even the experts don’t quite know what’s going on.”

In May 2009, the Wharton Business School noted regarding the analyst community that “[i]t’s not just that they missed it, they positively denied that it would happen.”

In the New York Times in August of 2013, we read that “[t]he trouble with economics is that it lacks the most important of science’s characteristics – a record of improvement in predictive range and accuracy.  In fact, when it comes to economic theory’s track record, there isn’t much predictive success to speak of at all.”      

And, finally, in January of 2010, Eugene Fama, the father of the Efficient Market Hypothesis, told the New Yorker “I’d love to know more about what causes business cycles.  I used to do macro-economics, but I gave up long ago.  Economics is not very good at explaining swings in economic activity.   We don’t know what causes recessions.   We’ve never known.”  Yes, my friends, feel free to read that again.   The father of EMH came out and told us that it does not work, and he gave it up long ago.

Mr. Prechter went further, as he then outlined the reasons why such analysis has been an absolute failure in chapter 15 of his book.   Whereas the law of “supply and demand operates among rational valuers to produce equilibrium in the marketplace for utilitarian goods and services . . . [i]n finance, uncertainty about valuations by other homogenous agents induces unconscious, non-rational herding, which follows endogenously regulated fluctuations in social mood, which in turn determine financial fluctuations.  This dynamic produces non-mean reverting dynamism in financial markets, not equilibrium.”

Moreover, since the efficient market hypothesis (the basis for fundamental analysis in financial markets) is an outgrowth from the world of economics, it has become quite commonly viewed as an unworkable paradigm for financial markets (as noted above) for various reasons.  Understanding that an underlying assumption within economics is ceteris paribus, and an underlying assumption in the efficient market hypothesis is that all investors act rationally and with the same knowledge, you can easily understand why it is simply unworkable in financial markets.

In fact, Benoit Mandelbrot outright stated that one cannot reasonably apply an economic model to the financial markets:

“From the availability of the multifractal alternative, it follows that, today, economics and finance must be sharply distinguished . . .”

From an empirical standpoint, consider that, within economic theory, rising prices result in dropping demand, whereas rising prices in a financial market leads to rising demand.   Yet, most continue to incorrectly apply the same analysis paradigm to both environments.   

So, I will repeat my premise.  As most of you, I started my investing career with fundamental analysis.  Yet, I have abandoned it when analyzing the overall market because analyzing market sentiment has been a much more accurate lens through which to view the machinations of the stock market.  And, those that have followed me through the years can attest to this fact. 

With all this being said, I want to now explain why I view fundamentals as important. Remember that market sentiment is the primary driver when we are dealing with investment products wherein mass sentiment is evident. However, this is not an absolute perspective. Rather, it is based upon a continuum of sentiment.

You see, while the SPY is an example of an investment product that presents us with the ultimate in mass sentiment, a microcap biotechnology company may be on the opposite end of that continuum of sentiment. Within the example of the microcap, sentiment can be a factor, but the fundamentals of the company are going to be the primary driver of this stock. And, all products run somewhere within that continuum. The greater the mass sentiment being evident within the buying and selling of that product, the greater probability that sentiment will be the driver of price. And the reverse is true.