Wojciech Stępień (private archives)
Obserwator Finansowy: Are markets efficient?
Wojciech Stępień: Eugene Fama’s hypothesis assumes that the market always has complete information about everything. But this is just a theory. In practice, it is not the case that the market is perfectly efficient at all times.
So, what exactly are the prices on the stock markets telling us? There is a popular opinion that the stock market is a leading indicator for the economy. Is that a myth?
This is definitely not a myth. In general, the assumption is that the better the condition of the economy, the higher the profits of companies. And the more profitable the companies, the higher the prices on the stock markets. That is why the indexes may suggest which way the economy is heading. It is therefore a good leading indicator – because the changes in the economic situation always start at the micro level, and only then the micro level affects the macro level. After all, both the economic indicators – such as the purchasing managers’ indexes (PMI) – and the hard data that follow them – such as output or sales volumes – are a consequence of what is happening at the micro level, that is, in individual companies. Of course, then there are also the issues of liquidity, the central banks’ activities that influence the market, and that distorts this mechanism and can cause overshooting or undershooting.
In Poland, however, the usefulness of the stock market as a leading indicator is more controversial, as the composition of the main index of the Warsaw Stock Exchange, the WIG20, is detached from the economic situation and the structure of the economy.
So how is it possible that the S&P 500 has recently reached all-time highs, even though neither the United States’ economy nor the global economy look like they are going to quickly make up for the losses caused by the pandemic?
We had an exceptionally short bear market, that’s true. But the slump was also unprecedented in its nature, as it was caused by administrative decisions on the introduction of the lockdowns. The fact that the S&P 500 is so high does not translate into the level of GDP. But, there is a relationship between the direction of changes in the market and the situation in the economy. If the economy is improving, then the market is rising. Since September, we have been seeing drops on the stock markets following strong increases in the preceding period. And the situation is similar in the economy. At first, there was a dynamic recovery, but we can see that the pace of the rebound has slowed down.
“Stock prices are reacting to the narratives.”
Sometimes there are overshoots and undershoots, but there is always a point when the stock prices align with the levels that confirm the efficiency of the markets. The stock prices are reacting to the narratives.
Narratives? How should we understand that?
As the market implications of changes in the economic realities.
So, a narrative is some interpretation of the economic events, combined with the expectations concerning the further development of the situation in the markets, which is believed in by the majority of the market?
Yes, and this belief translates into investment decisions. The narrative may be true, when the changes in the economy are in line with the expectations. In such case, the trend, the direction in which the market is going, is continued. But sometimes the narrative may be false. If the reality turns out to be different from the dominant narrative, then there is a market adjustment, that is, a correction. And then the market searches for a new narrative.
What would such a false narrative look like?
For me, one such example was Bitcoin. There was a prevailing narrative that Bitcoin would ultimately replace the global currencies and that in just a moment we would all be paying with Bitcoin. But anyone who has any experience and who understands how the financial system works, was aware of the fact that no central bank would ever accept Bitcoin. And without central bank money, there are no guarantees. Money is an element of the economic policy. The people who were promoting such a narrative around Bitcoin probably didn’t understand all these things. Its enthusiasts probably had good knowledge of how computers work, but they didn’t necessarily understand how the financial market operates. This narrative pushed up the price of Bitcoin, but it was clear that it was false. And then this narrative collided with reality. That’s the way it works.
Sometimes, however, the markets indeed become detached from reality.
It is rarely the case that reality has to adapt to what is happening in the market. It seems to me that more frequently we are dealing with a situation where people simply don’t appreciate reality. Oftentimes when I’m observing the market and something happens that I don’t understand, or something doesn’t feel right to me, I try to identify what is there that I’m not seeing. This is my first impulse – to look for gaps in my own knowledge and observation of the world, and not to conclude that the market has become detached from reality.
In such situations – of unexpected changes in the market – we can observe the formation of narratives. Something unusual is happening, and at first it seems that the market is “going bananas”, but then some explanations and interpretations emerge. Over time, more and more people start repeating them, and after a month passes, everyone simply “knows” that the market is rising for this reason or another.
The key players – such as fund managers, who are able to move the markets – are usually observing the macro situation. And when they see that the markets are overshooting or undershooting, then they are not writing reports about this, but are making investment decisions that can change the direction in which the markets are going. When the analysts, economists and other market participants see this, they start looking for arguments in favor of changing the narrative, and they verify their assumptions. If more investors join in, and the evidence confirming a new narrative begins to prevail – then it becomes dominant.
That was the case before the last presidential elections in the United States. The analysts all predicted that Donald Trump’s potential victory, although highly unlikely, would lead to a collapse on Wall Street. It turned out, however, that Trump won, and the stock markets continued to rise. Pretty soon, new explanations emerged, which have come to be treated as obvious: that after all the political program of the Republican candidate includes large investments, tax cuts, etc.
It should be noted, however, that there were initially some drops after Trump won. The situation was similar with Brexit – everyone expected that it would not happen, and after the results were announced, the British pound experienced a sharp decline. The markets are also wrong sometimes, these things happen.
There is no controversy as to the effectiveness of the markets over the long term. The only questions concern the short periods as well as the overshoots and the undershoots. It happens especially during periods of increased uncertainty – when it is difficult to formulate the appropriate narrative and the appropriate expectations. And this is why we had such strong drops in the stock markets in March – no one knew what was going to happen, there was no precedent for such a situation.
So, the market didn’t have anything to assess, because there was simply no information available?
But that is not an argument for the lack of effectiveness. Quite the opposite. Such moments – of increased volatility – show that the market is looking for the proper interpretation. The fact that sometimes there are overshoots or undershoots doesn’t change that.
Do these overshoots or undershoots cancel each other out over the long term?
In practical terms, these are sometimes the inevitable consequences of effectiveness, but in the long run, the market efficiently reflects all the factors that influence the valuation of assets: the economic issues, the issues of liquidity.
There is a narrative that the Fed will never allow the US stock market to fall. Is it justified?
I think that this relates not only to the Fed, but more broadly, to the entire American administration. However, the most important thing is the role that the capital market plays in the United States. Over there, the so-called wealth effect and the level of involvement of individual investors is remarkably high. Additionally, there is no universal social security system – every person saves money on their own and investment portfolios are largely based on shares. Because of that, the motivation for politicians to act is much greater than in other countries. The functioning of the economy is based, to a much greater extent, on the capital market. Therefore, in times of large drops there are more reasons to prop up the market.
“The central banks can theoretically do “whatever it takes” and the restrictions on their activities are much lower than it seemed.”
Another thing is that due to the size of the US economy and the role of the US dollar in the global financial system, the Federal Reserve simply has a lot more power and can afford to do a lot more. Not so long ago, we didn’t realize that central banks can theoretically do “whatever it takes” and the restrictions on their activities are much lower than it seemed. Now we know that if the central bank is able to do something and has strong enough incentives – then it will do it.
Because of that I think that the market’s belief – that the Fed is able to act and is effective in these actions – is ultimately justified. The same goes for the belief in the motivation of the American politicians, who are willing to stimulate the economy in this way. I think that the long-term, multi-annual upward trend will continue if we don’t collide with a systemic crisis in which the Fed would become powerless. But, for the time being, nothing seems to indicate that such a crisis may be on the horizon.
And what is the significance of market narratives for a macro-economist?
The macroeconomic projections are based on certain assumptions. In normal conditions the attempts to predict the future are based on an extrapolation of what is happening now, and on the stage of the business cycle that the economy is currently in. These models are static. However, when a shock comes, it is no longer possible to make forecasts based on extrapolation. In the case of the coronavirus, it was necessary to assume how long the lockdown would last, when would private consumption bounce back and to what extent, and when would investments return. This could not be inferred from the models, because this was a situation without precedent. And in such situations, it’s worth following the scenarios and the assumptions suggested by the market.
But, the market was also changing its direction – from the sharp drops at the beginning of the pandemic, to the rapid increases recorded in the summer, and then back to the decreases observed in the autumn.
At the beginning, when everyone was still in lockdown, a consensus emerged among economists that the world likely wouldn’t return to normal functioning for year and a half, and that people would be very cautious about consumption. This narrative was also adopted by the markets and there was a collapse. However, a counter-narrative soon emerged. Someone decided that these assumptions were overly pessimistic – and started buying up assets. More and more arguments in favor of this view emerged, and more and more investors joined in this movement. And then a quick rebound in the economy became the dominant narrative.
So, what is the conclusion that an economist can draw from this?
The role of an economist is to predict the future of the economy. The market has forecasting capabilities. While it is not possible to forecast GDP based on the behavior of stock indexes, the market may still be useful nonetheless. If the market starts to behave in a manner that is inconsistent with the prevailing macroeconomic consensus, that is, if the market narrative starts to diverge from the economic narrative – it is a signal that maybe it’s time to verify the assumptions underpinning the models.
– interview by Maciej Jaszczuk
Wojciech Stępień is an economist at BNP Paribas. He analyzes and prepares macroeconomic forecasts for the countries of Central and Eastern Europe. Previously, he worked as an analyst at Raiffeisen Polbank and as an economic journalist at PAP Biznes.