Rational irrationality

Don't blame crazy investors for the stock market's wild ups and downs; they're just being sensible.

Topics: Stock Market,

Market-watchers seeking yet more evidence that the euphoria associated with the technology stock boom has been dispelled needed look no further than Monday’s New York Times.

We were informed that “incubator” companies that provide advice, funding, administrative support and marketing to fledgling Internet companies, intending to nurture them to profitability, or at least a lucrative IPO, are now despised, and that the firms that bear that name are shunned by investors. Apparently, buzz is no longer what the investors are after. According to the Times, investors are pulling their money out of the once-popular “growth stocks” and returning to so-called “value funds,” which look closely at annual reports, economic indicators and other unromantic data to find sound companies whose stock price is unjustifiably low. It seems investors’ notorious “irrational exuberance” has finally passed.

Back in the days when technology stock prices were in the stratosphere, banks rolled out a continuous stream of IPOs and it seemed that any 28-year-old with a talent for technospeak could pull in $10 million in venture capital funding, the public was consumed by a debate: Had things gone too far? Was the market out of whack? Had we left rationality permanently behind? As Yale economist Robert Shiller put it, the market was in a state of “irrational exuberance.” Mass psychology had driven stocks to levels far beyond the underlying values of the companies.

But some argued that irrational exuberance might not be irrational after all. With the development of revolutionary new technologies, there was no reason stocks shouldn’t continue to rise, perhaps even bringing the Dow up to 36,000. Then the market collapsed, and the debate died down. Shiller et al. seemed to have won the day. The market had been out of whack, it was agreed; now a “correction” had ensued and rationality would be safely restored. Still, it was little noted at the time that this consensus doesn’t quite work doctrinally. The drop of over 1,500 points in the NASDAQ, without the surfacing of dramatic new information, is not the way rationality is supposed to operate.

Our new “value” market continues to produce swings that leave stockholders reeling. The NASDAQ soared 242 points or 7.9 percent Oct. 13, the second biggest percent change in the market’s history. It quickly lost most of that gain, only to rise another 247 points Oct. 19. At that time, many analysts expressed the hope that the market for technology stocks had finally “bottomed out.” But it wasn’t to be. Last Wednesday the NASDAQ dropped another 190.22 points, losing 5.56 percent of its value. True, recent price movements have been tied to earnings reports and international events in a way that they weren’t last winter. But stock prices have been moving with a violence unjustified, in orthodox “rationalist” accounts, by the data coming in.

Take the case of Nortel Networks, the Canadian telecom equipment maker whose disappointing earnings report precipitated the NASDAQ’s plunge last Wednesday. The news that Nortel’s earnings were $300 million short of expectations resulted in a $55 billion drop in the company’s market value. That doesn’t seem quite right, does it? And investors fled from other fiber-optics stocks as well, even though it was far from clear that they were experiencing the same problems as Nortel. It used to be that investors were happy to buy a stock with barely a glance at earnings reports, now they panic at the first sign of a shortfall.

So maybe the market’s dizzying movement should dispel the hope that we have returned to the safe harbor of rationality, basing our investment decisions on how a company is actually performing, rather than how popular it is with investors. But I would propose an alternate conclusion — that the market is just as rational as it was last year, or even 10 years ago. And that, in fact, rationality is a pretty useless way of talking about the stock market, one that imputes motive to a inanimate system, mischaracterizes the reasons why people buy stocks and misapprehends the real function of valuation techniques and the analysts who use them.

By way of analogy, I’ll offer a brief anecdote. I recall a Spanish professor from my freshman year of college, a man of luxuriously curling hair and left-wing politics, who took great pleasure in challenging my Enlightenment-era worldview. “Man,” he declared (in Spanish), “is the least rational of the animals. If an animal is hungry, it eats. When tired, it sleeps. Humans are the irrational ones. We are the ones who starve ourselves to protest injustice, who toss and turn in an agony of unrequited love.” I was dismayed. Wasn’t Man defined by his rationality? Wasn’t our ability to Reason and to apply Logic what set us apart from other animals? But I couldn’t quite disprove his formulations. In the end, I threw up my hands — perhaps the true nature of man was unknowable. Looking closer, however, I can see that our vague use of the word “rational” had obscured the more concrete questions we had raised. The same is true for the stock market debate.

Fundamentally, an investor can obtain profit from a stock in two ways: by receiving dividend payouts from the company or by earning capital gains through selling the stock after it has risen in price. In today’s market, the latter reason has come to dominate investor motivation. In order for a stock to rise in price, other people must buy it. It is therefore “rational” for an investor to try to predict the inclinations of the rest of the existing and potential investor community. The question of whether a company is, in some objective sense, “good” or strong or profitable is really irrelevant to the investor, except as it affects others investors’ attitudes toward its stock. If other investors want it, then it’s valuable.

True, a share of stock is by definition a percent ownership in a company. But this is a legal abstraction rarely relevant in the real world. (Bankruptcy is the principal exception.) It is possible for a stock price to move independently or even inversely to the performance of the company. There is no reason why a drop in quarterly earnings must lead to a decline in stock price, except that each stockholder fears that others, reacting to the information, will sell their stock and wishes to escape the resulting depreciation of his assets. If investors could be persuaded that others would not sell their stock, the price would not fall. The issue, essentially, is the actions of other investors, not the status of the company.

Despite this fact, most stock analysts devote less time to an attitudinal investigation of the investing community than to an analysis of the so-called fundamentals: price/earnings ratio, dividend levels, etc. It’s not hard to see why. “Fundamental” research yields a more concrete, quantitative result and lends the financial professions greater legitimacy. Furthermore, in times of relative market stability, research into the fundamentals will lead to the same conclusions. All the other analysts are looking at the same data and the investing public is relying on their advice.

But methods of valuing stock are only as effective as the number of investors who subscribe to them. Those who discarded their price-equity calculations were scolded by purists for not sticking by the tried and true markers of rationality. But why should they, when the only reason that the P/E ratio was helpful in predicting stock prices was that everyone else was using it as well? Similarly, if the P/E ratio has become less helpful, it’s not because of new technologies or changing economic dynamics, but simply because enough people were persuaded that the old valuation methods were no longer where it’s at.

How is this related to my former professor’s provocations? It suggests that the way we have been discussing the stock market and investor behavior is inaccurate. Markets are “rational” in the sense that investors’ behavior is directed toward their self-interest and they will generally make reasonable choices to promote that interest. The problem occurs when the word “rational” is used as a substitute for “efficient,” or to suggest that stock price should conform to other measurements of the value of a company. Often stock prices will reflect these external value measurements, but only when investors are collectively possessed by the belief that it should. The discarding of P/E ratio and other traditional valuation methods may not be a good thing. It may contribute to the market’s volatility, exposing the investor to greater risk and companies to greater instability. But the Internet stock boom did not make the market more or less “rational.”

If anything, last year’s boom — and this month’s roller coaster — have only exposed the extent to which market movement is, and has always been, based on perception, psychology and convention.

Elizabeth Arens is an editor at Policy Review.

More Related Stories

Featured Slide Shows

  • Share on Twitter
  • Share on Facebook
  • 1 of 11
  • Close
  • Fullscreen
  • Thumbnails
    Burger King Japan

    2014's fast food atrocities

    Burger King's black cheeseburger: Made with squid ink and bamboo charcoal, arguably a symbol of meat's destructive effect on the planet. Only available in Japan.

    Elite Daily/Twitter

    2014's fast food atrocities

    McDonald's Black Burger: Because the laws of competition say that once Burger King introduces a black cheeseburger, it's only a matter of time before McDonald's follows suit. You still don't have to eat it.


    2014's fast food atrocities

    Domino's Specialty Chicken: It's like regular pizza, except instead of a crust, there's fried chicken. The company's marketing officer calls it "one of the most creative, innovative menu items we have ever had” -- brain power put to good use.


    2014's fast food atrocities

    Arby's Meat Mountain: The viral off-menu product containing eight different types of meat that, on second read, was probably engineered by Arby's all along. Horrific, regardless.


    2014's fast food atrocities

    KFC'S ZINGER DOUBLE DOWN KING: A sandwich made by adding a burger patty to the infamous chicken-instead-of-buns creation can only be described using all caps. NO BUN ALL MEAT. Only available in South Korea.

    Taco Bell

    2014's fast food atrocities

    Taco Bell's Waffle Taco: It took two years for Taco Bell to develop this waffle folded in the shape of a taco, the stand-out star of its new breakfast menu.

    Michele Parente/Twitter

    2014's fast food atrocities

    Krispy Kreme Triple Cheeseburger: Only attendees at the San Diego County Fair were given the opportunity to taste the official version of this donut-hamburger-heart attack combo. The rest of America has reasonable odds of not dropping dead tomorrow.

    Taco Bell

    2014's fast food atrocities

    Taco Bell's Quesarito: A burrito wrapped in a quesadilla inside an enigma. Quarantined to one store in Oklahoma City.


    2014's fast food atrocities

    Boston Pizza's Pizza Cake: The people's choice winner of a Canadian pizza chain's contest whose real aim, we'd imagine, is to prove that there's no such thing as "too far." Currently in development.


    2014's fast food atrocities

    7-Eleven's Doritos Loaded: "For something decadent and artificial by design," wrote one impassioned reviewer, "it only tasted of the latter."

  • Recent Slide Shows



Comment Preview

Your name will appear as username ( settings | log out )

You may use these HTML tags and attributes: <a href=""> <b> <em> <strong> <i> <blockquote>