They are an odd bunch, the Voices of the City. Flitting between TV studios in the early hours, with their clip-on ties and clip-on opinions, they dispense 30-second sound-bites on any given subject before being chauffeured onwards and parked in front of the next available camera.
Last month, when world stock markets were about to turn six-year highs into six-month lows, why were so few of these experts sounding the warning siren? Why did they all wait until June to adopt that tired old maxim about selling in May and going away? And, in the aftermath, why do they still expect us to keep listening? Certainly, anyone who has read The Wisdom of Crowds will have their fingers in their ears. James Surowiecki’s international bestseller argues the case for the many against the few, suggesting that large groups of people will tend to predict things more accurately than experts. The theory runs that, while professional cliques tend to think alike and compound each other’s mistakes, the errors made by a sufficiently large crowd will cancel themselves out to reveal a core truth at the mean, even when the crowd is made up of less-informed individuals.
That is, in general terms, how some people believe that financial markets ought to work. A stock index should do nothing more than distil a million independent guesses, so it can arrive at a single number that provides a minute-by-minute gauge of common wisdom about the state of the nation’s biggest companies.
It does not matter whether lone investors are basing decisions on the advice of George Soros or Mystic Meg — an efficient market should still be able to average out all the rogue elements and come up with a price that discounts all the available information.
This efficient market hypothesis is controversial — not least because, if correct, it would make all the City tipsters redundant. Investors buy assets because they believe that the price paid does not fully account for its future worth. Yet if the price has already discounted an entire universe of information before purchase, the investment represents nothing more than a heads-or-tails gamble. It should be pointless for an individual to try to outsmart the market because the market will always have anticipated at least as much as the individual.
Advertisement
Luckily for the tipsters, financial markets rarely seem to work all that efficiently. In recent weeks, hundreds of billions of pounds have been wiped off equities amid a panic about rising inflation and interest rates. That panic, in turn, has magnified the significance of news that in calmer times would barely have created a ripple. Before May who would have believed that the FTSE 100 could drop more than 2 per cent in a day because of a South Korean rates decision, or an even-handed speech from a minor Fed official? What makes this particular panic look so irrational is that, while investors’ billions disappeared, nothing fundamental has changed. Economists forecast world growth next year of 3.1 per cent, exactly as they did six months ago. The corporate earnings outlook has barely budged. Nor have interest rate futures. That has led many, including the City’s self-elected experts, to argue that the sell-off has been a spectacular overreaction to nothing.
What they do not recognise is that the nothing was the problem. The panic was triggered not by a specific piece of information, but by an information deficit. And, under the efficient market hypothesis, this is completely rational.
While the world economy looks much the same as it did a few months ago, the range of possibilities about what could happen in the future has widened markedly. Every time a commodity price wobbled, a currency flipped or a central banker fudged an answer, investors have had a little less to put into their spreadsheet. And the less information that goes in, the more random the predictions become.
Even tiny variations in near-term interest rates, spending and cost assumptions have a huge effect on earnings forecasts. Every uncertainty, therefore, produces an ever-widening range of forecasts about what may happen a few years down the line. Left in the dark, investors have had to squeeze every possible outcome from each sliver of news, which creates stock market volatility. Or they may choose to give up, shut down the spreadsheet and put their money somewhere safe, which creates stock market declines.
Another maxim among the talking heads is that the market has forecast nine of the past four recessions. If trends continue, it could soon be pointing to another. Can anyone bet with confidence whether this prediction will turn out to be right or wrong? The City Voices have licence to be wise after the event. But for the moment, for those not willing to take the risk, it may be safer to listen to the crowd.