Robert Prechter Dispels 10 Popular Investment Myths

Posted by Robert Prechter - Elliott Wave International

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Interest rates, oil prices, trade balance, earnings, GDP, wars, terrorist attacks, inflation, monetary policy, fiscal policy, etc. — NONE have a reliable effect on the stock market.

This is the last part of the series “Robert Prechter Dispels 10 Popular Investment Myths,” where EWI president explains why traditional financial models failed in 2007-2009 — and why they are doomed to fail again (and again).

The Socionomic Theory of Finance
The Conventional Error of Exogenous Cause and Rational Reaction

Reasoning in Reverse: from Market Actions to Prior Causes

We have investigated [see Parts I-XI — Ed.] whether one can find any consistent cause of financial market price changes by looking at dramatic events and trying to tie them to market movements. What if one reverses the investigation to look for dramatic price changes first and then try to fit them to causal events?

In their 1989 paper, Cutler, Poterba and Summers investigated just such situations. Starting with days during which stock prices moved dramatically, they scoured the news to find exogenous causes. Their conclusion is stunning: “…many of the largest market movements in recent years have occurred on days when there were no major news events.”

In other words, whenever the stock market was leaping or plummeting on any particular day, there was often no news sufficiently striking to explain it. And it happened regardless of the fact that there is lots of news all the time, providing substantial opportunity for data fitting, which is what financial reporters do at the end of every trading day and what many economists do in their monthly reports. The evidence from this study of news events and market action contradicts the exogenous cause paradigm.

Perhaps you are thinking that important background conditions are trumping daily events. Surely the two most dramatic price changes of the past century have clear causes. Or do they?

Economists of all stripes have tried to come up with an explanation for the 1987 crash. Yet in a 1991 paper, four years after the fact, William Brock studied economists’ commentaries and concluded, “In my opinion, no satisfactory explanation has been found [for] the most recent crash…Black Monday, October 19, 1987.”

What about the most devastating event of the 20th century, the Great Depression and the collapse in stock prices that led to it? The Winter 1999 issue of the Federal Reserve Bank of Minneapolis’ Quarterly Review observed, “Economists and policymakers are still studying and debating what caused this catastrophic economic event.” Dissatisfied with this fact, the Minneapolis Fed “decided to find out what caused this event.” So, in October 2000, it held a conference titled “Great Depressions of the Twentieth Century.” It invited 56 noted economists, including a Nobel laureate, the current chairman of the Federal Reserve, economists from various Federal Reserve banks, and professors from the University of Chicago, U.C. Berkeley, Carnegie Mellon, Brown, Penn, Stanford and other top schools. …

Two months later, the Minneapolis Fed’s quarterly Review filed its report on these presentations. Pertinent excerpts are as follows:

A guiding premise of the conference was to apply neoclassical growth theory…to events that occurred over 60 years ago, in the hopes of shedding light on one of the most vexing questions in economics. …As one economist said in the middle of his presentation: “And then, in 1933, something unanticipated happened.” The task of those gathered in Minneapolis was to explain how those unanticipated events caused these economic depressions.

Although many causes have been suggested for the Great Depression, economists have yet to agree on a uniform explanation. The standard approach of the profession since the 1940s has been to try to determine the causes of the depression by searching for relationships or correlations in the data. But since the Great Depression was so unique, there is no basis for comparison and, therefore, empirical analyses always come up short.

In the end, if the Great Depression is, indeed, a story, it has all the trappings of a mystery that is loaded with suspects and difficult to solve, even when we know the ending; the kind we read again and again, and each time come up with another explanation.

In a line loaded with irony, the article notes, “It may strike some as odd to describe economists as storytellers, but it’s a term they use when discussing themes and ideas.”

These commentaries are dated December 2000, 78 years after the bottom of the Great Depression. Economists have had eight decades to extract something of value out of their exogenous-cause model, only to find that it offers no useful answers and no explanation upon which its proponents can agree. Remember, we are not even asking economists of the time to have predicted the event. As history reveals, the opposite occurred; the most famous economists assured the public that nothing of the kind was on the horizon, that the economy had reached “a permanent plateau.” Considering that we seek only a retrospective explanation from this report, a more damning indictment of the exogenous-cause paradigm could hardly be imagined.
When you are brilliant, your mind is rational, your logic is sound, and yet your conclusions are continually wrong or inadequate, there is only one explanation: Your premise is false.

We have shown that the phrases “interest-rate shock,” “oil-price shock,” “trade-balance shock,” “earnings shock,” “GDP shock,” “war shock,” “peace shock,” “terrorism shock,” “inflation shock” (and therefore “deflation shock”), “monetary shock” and “fiscal shock” have no value (and in my view not even any meaning) when it comes to analyzing the behavior of financial markets. There must be something wrong with the premise behind these terms.

To summarize our findings up to this point:

1) No type of exogenous event leads to a consistent result in financial market movement.
2) The biggest stock market movements have no clear exogenous causes even in retrospect.
3) There are no consistent correlations or relationships between supposed exogenous causes and market results.

Why the Failure of Exogenous Causality Is Not Often Apparent to Most Observers

Most of the time, the stock market rises and the economy expands. During such times, economists confidently cite half a hundred various exogenous causes to explain the growth that is occurring. Even though the explanations are either tautological (“the increase in jobs has fueled a pickup in GDP”) or bogus (and refutable in every case by showing a single historical graph), no discernible cognitive dissonance occurs among economic theoreticians or practicing economists and their clients. All these people feel comfortable, so they accept the adequacy of the explanations and demand no evidence.

But when people are uncomfortable, they begin to seek valid explanations, which do require some evidence. People are uncomfortable during bear markets and economic contractions, so this is when they actually bother to investigate economists’ theories, methods and explanations.

At such times, the theories, methods and explanations are always found wanting. They are just as wanting when times are good, but during such times no one bothers to check.