There is a latent sentiment “out there” that there is something wrong with mainstream economics, at least insofar as it is used for generating investment advice. Keep in mind that in the land of the blind, a one-eyed man is King, and he can keep it all quiet just like a trade secret.
The conventional wisdom on the capital markets starts with the idea that the real economy has a life of its own, following something that some economists call the Real Business Cycle, or what Keynes called “animal spirits.” Stock markets try to anticipate the business cycle, which is why pundits joke that stock markets have called up “ghost” recessions whenever they tank but the economy remains good. Bond markets also have lives of their own, which means that they are difficult to predict. But nonetheless bond markets tend to lead stock markets because of portfolio considerations: when bond yields rise, bonds become more attractive, so that a stock market boom tends to lose steam. There is a self-reinforcing character to this conventional story because a rise in interest rates tends to slow down investment and thereby also the broader economy.
What do the big investors and fund managers do based on the conventional wisdom?
Supposedly, they have economists or other similar analysts on call to predict the business cycle. That allows them to anticipate stock markets. They also employ Fed watchers to divine where interest rates will go. That allows them to anticipate bond markets.
The trouble is that everyone is doing pretty much the same thing, and it is no surprise that their efforts tend to become self-fulfilling for a while, and everyone congratulates everyone else for being “great money masters,” worthy of their hefty Wall Street perks.
But they also make mistakes. The typical mistake is to think the economy will always remain good, so that a stock market crash is the eventual outcome, where the characteristic feature is a panic mind-set of “Every man for himself.” When they are right, it is typically when they are optimistic, but then this results in a bull stampede. Of course these errors set up the classic greed-fear/mania-crash financial crisis cycle. When they don’t really know what’s going on, they won’t admit it, but then it becomes a boring ho-hum market. Bloomberg et al have to work double time to generate investor interest.
What should the small investors do in this environment? In theory, because they are small, their actions cannot guide or influence the markets. They should therefore anticipate the mistakes that the big boys will make. The small investors have to be smart enough to know when there is greed or fear in the markets. When there is neither, it is perhaps safe to say that stock and bond prices are “about right.”
What if it could go either way? Some big boys are afraid; others are greedy. For example, today, the big boys think that most of them believe in economic recovery, while a quarter of them think a “double dip” is on the way. What should the little guy do?
The answer is the equivalent of the Holy Grail of finance and economics.
NB: For the big boys, it doesn’t matter very much whether they are wrong. This is because they earn fees for managing other folks’ money even when they make mistakes. It pays to be lucky, of course, since then a big-boy manager gets bigger business. And if a manager gets to be big enough to have a following (for example, Buffett or PIMCO), they can have an easy time initiating trend-based results and “getting out early.” It seems the only way such managers will lose is when they lose followers, so it becomes a cat-and-mouse game of letting the mice have a share of the pickings, enough to get them to continue to follow. The story of the Pied Piper readily comes to mind.
And if they understood Nassim Taleb right, they know there is no such thing as a “new normal.” So why peddle it? They must think we are all morons. But with just one big unlucky break, i.e., one Black Swan a la LTCM, the “easy game” is over. Myron Scholes should know.