Lehman's Lesson: Market ≠ Machine

by: Patrick Schotanus

It is about the real value of a real education, which has almost nothing to do with knowledge, and everything to do with simple awareness; awareness of what is so real and essential, so hidden in plain sight all around us, that we have to keep reminding ourselves, over and over: "This is water, this is water."

David Foster Wallace

Commencement speech, Kenyon College, 2005

We just "celebrated" the fifth anniversary of the demise of Lehman. Let's go back to that moment, in 2008. Do you remember how it felt? Those of us who were "in the market" at the time most vividly do. Regardless of whether you were a bull or a bear, we all became rabbits caught in the headlights of the events surrounding its collapse.

We are still trying to get to grips with it (as well as with the resulting Great Recession), leading to a lively debate over both the cause and the cure. Many academics and practitioners in investment management participate in this debate because they realize that there are lessons to be learned. The following lesson, albeit not easy, is the most crucial of all.

The cause for our problems originates from ontology, concerning the nature of capital markets. Specifically, the prevailing paradigm of modern finance promotes the flawed perspective of the market as a machine. This commits Hayek's "outright error," which gets us into Keynes' "colossal muddle," for example. Instead, based on the stylized fact that we are not machines, but they our extensions, I propose the premise of the market as a mind-body. This in turn has implications for our knowledge (epistemology) as well as for our research applications (methodology), including our models. It is particularly relevant in light of the elusive intangible issues that underpin our fiat money financial system, like mood and trust.

On that note, Lehman was a reality check. We experienced a near fatal market stroke and escaped it more by luck than wisdom. Crucially, it didn't feel like a machine breaking down at all. Instead, what came over us was the shared sensation of paralysis which accompanied the market seizing up. It was this overwhelming experience that impresses how it is like to collectively be in such an existential market state as humans.

We can only imagine how much worse it could have been. I am not referring to the usual apocalyptic image of empty ATMs, shelves and streets (except for the stray dogs). Rather it is the ceasing of consciousness through which we intimately know the market as an animated entity. Even if the embodied knowledge in principle survives in books, electronic files and isolated human minds, it is stale - finance's version of 'the end of the world as we know it'. The market is a patient who enters into a coma or worse; a changed reality. This is more than just a metaphor.

In fact, all market states are infused by ineffable 'raw feelings' that vary in uniformity and contribute to market awareness. For example, in extremis they swamp subjectivity whereby individual investor mentality converges towards single-mindedness with obvious consequences, for example, for portfolio diversification. From an immediate economic survival perspective, being sensitive (e.g., contrarian) to this dynamic is of particular significance when you have 'skin in the game'. Indirectly, such experiential market knowledge concerns us all because of the growing influence of capital markets due to globalization, financialization and marketization.

On the one hand this mind-body perspective is simply formalizing a concept that we are already familiar with, namely the market's mind. For example, nobody wonders what George Soros means when he subtitles his book as "Reading the Mind of the Market". And it was Benjamin Graham, mentor of Warren Buffett, who introduced us to the schizophrenic "Mr. Market," whose mental state swings back and forth between euphoria (mania) and despair (depression).

On the other hand, this proposition is profound and the implications of accepting it are not sufficiently appreciated. We received an early clue of these implications from behavioral finance, the messenger of an emerging paradigm. But the box it delivered contains many more "disturbing" insights from the mind studies beyond its message of heuristics and biases. They vary from the unconscious, via number sense, to mirror neurons. Crucially, this premise inevitably leads to finance's version of the eternal quest in the mind studies: the mind-body problem, aka the problem of consciousness.

The market's mind-body problem asks why the quantities involved in physical processes and cognitive content give rise to the qualities of the market. In other words, how does the interaction between the physical properties (e.g., real assets) and the cognitive properties (e.g., expectations) lead to market states as we experience them in the phenomenal sense? A particular issue is that of mental causation, something Karl Popper explained as follows:

There is no reason (except a mistaken physical determinism) why mental states and physical states should not interact. (The old argument that things so different could not interact was based on a theory of causation which has long been superseded.) If we act through being influenced by the grasp of an abstract relationship, we initiate physical causal chains which have no sufficient physical causal antecedents. We are then "first movers," or creators of a physical "causal chain."

Soros, a student of Popper, translated it in investment terms via his concept of reflexivity, which deals with the questions of whether and how prices impact the fundamentals. Mental causality also relates, for example, to the policy of the Federal Reserve to target the stock market in order to generate the magical wealth effect.

Modern finance does not face up to this problem. Admittedly, addressing it turns the box delivered by behavioral finance into the Pandora kind. Among others, it forces finance to confront market reality and make the right ontological commitment, regardless of the costs of any epistemological revisions. That is to say, usually ontological commitments are expensive but in our case they are dwarfed by the costs we will incur by not making this commitment. Or worse, commit Hayek's "outright error" and end up in Keynes' "colossal muddle" by committing (as we have done) to something "different in [our] nature altogether."

So what is market reality? In simple terms, unlike objects in nature, capital markets do not exist "when nobody is looking." Capital markets exist because our collective physical and cognitive processing culminates in a phenomenal overlay, which completes our intersubjective experience of them, in particular via price discovery. A market's state exhibits, with prices as bridging symbols, a collective allocation to material as well as mental resources and only the totality of market experience exhausts the possible information about this state.

This realization, committed to as a mind-body, enables us to identify questions and answers along the lines of ontology, epistemology and methodology. Consequently this clarifies our debate, which often suffers from category mistakes and other fallacies, including confusing Occam's broom with his razor. Moreover, it frames and judges fashionable topics such as monetary policies, regulations, ethics and high-frequency trading in the proper format. For example, as Bernstein noted in "Against the Gods", it has become human nature to control nature and capital markets play an increasing role in that endeavor. Still, the development of modern markets covers less than one basis point of the evolution of human minds. So why do we, motivated by "recent" events, increasingly rely on mechanistic approaches such as Value-At-Risk, to deal with our world when, looking back over the full sample of human events, a balanced approach seems more valid? Specifically, our imagination and creativity in "discovery" were crucial in spawning the intuitions and insights that inspired our knowledge and contributed to our evolutionary success in what always has been a complex world. Talk about survivorship bias! More worryingly, the implications of outsourcing our investment decisions to computer algorithms are completely underestimated. You think a flash-crash is scary? Wait until you've seen the market's singularity.

To conclude, it is time to move on from the initial message of behavioral finance to its logical conclusion, the mind-body perspective. Its complementary view helps with reminding ourselves over and over: "This is markets, this is markets" (to paraphrase Wallace). The next step is to study the markets through this prism, which we can then use to draw "gems" out of the box. Specifically, the exclusive use of analytical methods is the reason why modern finance fails to comprehend something like mood, which escapes axiomatic capture. We also need different tools, like new software, to achieve this. Excel simply won't do! Complementary tools inspired by the insights from mind explorers like David Chalmers, Antonio Damasio, Gerald Edelman, Christof Koch and, yes, Carl Jung. In the process we turn Pandora's Box into a tool box to help think outside of it. But these are lessons for another time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.