The noise of markets
By Philip Bold, Portfolio Manager at Ethenea
There is considerable fluctuation in capital markets because market participants with heterogeneous expectations strive for the “true” price. Forecasts, which formalise the expectations for the future, fall short. They are based on implausible simplifications of reality.
Theory and practice often do not align in the capital market, even when it comes to the fundamentals, such as pricing. If the capital market is efficient – so goes the theory – rational market participants will ensure that new information is reflected in the prices immediately. However, this is not the reality: even in the absence of (price-relevant) news, erratic fluctuations occur. The myth of homo oeconomicus aside, which is a premise of theoretical models, the heterogeneous expectations of market participants and the shortcomings of forecasts contribute to the fluctuations we see in prices.
It’s a given that prices come about through the primary mechanism of supply and demand. What is key is the underlying reason, namely the expectation for the future, that prompts market participants to trade at the prices they do. The heterogeneous expectations of market participants gives rise to a price that reflects the future scenario that consensus opinion states is the most probable. If the expectation changes – even in the absence of (price-relevant) news, when, for example market participants adjust their forecasts and then trade – then the equilibrium price also changes. It oscillates constantly as a compromise between possible future scenarios.
Of course, not every market participant is in a position to model explicit future scenarios. This is generally something that analysts do, who have a substantial influence on consensus-building. Despite that, it is likely that every investor has at least implicit expectations for the future, which prompt them to transact. However, these forecasts – both explicit and implicit – tend to be more akin to stabs in the dark.
The claim of predictive power alone is worth a look. Forecasts are based on models in which reality is reduced to key points and relations. In economics, modelling is characterised by deterministic causal links. In other words, a certain input results in a clearly defined output. While this makes sense in the natural sciences where certain regularities apply, in economics, which, being a social science, is characterised by human judgment and human action, deterministic model outputs are problematic. This is because changing one input factor not only monocausally changes the output but also interdependently modifies the other input factors; in fact, entirely new factors may arise.
All decisions have implications
Pricing, investments, product changes, regulatory interventions: all decisions have implications for competitors, suppliers, customers and investors, which in turn react dynamically to changes. Reality is shaped by these self-referential relations. This changes systems as a whole. In economic modelling, the ceteris paribus assumption, which assumes that parameters remain unchanged, prevents this dynamic. Economic operators are not accorded the adaptability and flexibility they exhibit in reality. Forecasts therefore imply a certain precision that does not exist.
Despite these shortcomings, forecasts do not count for nothing. They serve as guides to estimate the risk-reward profile of asset classes and individual securities; not as firm estimates but as indicators of direction. While it is important to stick with a positioning that is based on robust assumptions even if the short-term noise says different, it is also essential to remain flexible and rethink positionings once new information calls into question the original rationale for the investment. Amid the noise of the capital markets, opportunities will always arise when market participants strive for the “true” price.
