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Mechanics Of A Great Story

Summary

We are storytelling animals and we make decisions based on prevailing narratives.

Financial markets simply represent collective expectations.

Changes in space-time of financial universe occur due to signaling.

As described in the previous post, we are storytelling animals and we make decisions based on prevailing narratives, which either support or try to break the underlying story. The longer some story unfolds, the less everyone cares about the facts and the more everyone tries to rationalize every new piece of information so it would support the underlying story.

Once again, thanks to the perfect Epsilon Theory, who perfectly formalize ideas, which I simply call behavioral, and put them in Information plus Game Theory context, here I will try to show how stories unfold over time and why fundamentals are always less important at the end of the growth cycle. By providing the underlying mechanics.

Let’s agree that financial market simply represents collective expectations of market participants. If prices go up, larger portion of market (in the terms of capital, not number of participants) have expectations that asset is undervalued at the moment. If prices start to fall, larger portion of market thinks that it is overvalued.

The act of buying or selling something transmits a signal to every other participant regarding one’s expectations. The combination of those signals may or may not have an effect on other participants. If it does, herding occurs. Otherwise, some participants simply convey their expectations without any global effect.

That’s the second layer. The first layer of signal generation occurs within every market participant. Without soul-searching mysticism, everyone in financial markets, before making a decision and thus signaling their expectations to everyone else, receives number of external signals themselves. According to combination of which the expectation is formed and thus the decision is made.

In order to explain it better, let’s draw. Imagine that you are presented with some investment proposition about which you have absolutely no information. Then your position would look somewhat like this:

Drawn at Academo.org

Where:

1)      X axis shows expectations about future asset price – positive to the right and negative to the left;

2)      Y is time axis (which we will not use for now) – flows outwards;

3)      Z is the level of conviction regarding X – the higher you get, the more convinced you are about the future;

4)      The red dot represents you current expectations and position;

5)      The shape of the surface, the steepness of it, shows how much new information one needs to form the corresponding expectations about future asset price – the steeper and higher the wings, the more convincing one needs in order to change their opinion;

You know nothing about the asset and thus you have no conviction regarding how high or how low it may get in the future. Thus the red dot stands in the middle at the valley – you expect that price of some equity may equally possibly increase and decrease.

However suppose that your trusted advisor gives you some research which tells that this asset is piece of shit. Due to this revelation, your position changes:

Drawn at Academo.org

Now you are convinced that price of this asset should go down because you received a strong signal (respected research from respected advisor) about it being overvalued. As the perceived external signal was strong, it makes the red ball move far and high.

However, this case revolves about you knowing nothing about the asset in the first place. What would happen if you knew something about this asset beforehand ?

Say you believe that asset is undervalued and that it is rational to buy it. Thus we start not at X=0, but at X>0 – you have positive expectations to begin with:

Drawn at Academo.org

In such case your preferences are skewed towards optimistic scenario. The most interesting is that in such case you need much more negative information (signals) in order to change your opinion from positive to negative. While only a bit of nudging would make you even more convinced that this asset is great investment opportunity.

You are already anchored, subjected to confirmation and possibly sunk cost biases. Due to fallacies of human decision making process, you will be much less likely to sell this asset despite being presented with empirical evidence showing that it is overvalued. That’s how prejudice works – it is easy to convince someone about something they have no idea about. Nevertheless, it takes so much more to convince them otherwise afterwards.

Up until now the discussion revolved around expectations formed by a single person – you. However let’s suppose that the red ball is not your personal opinion, but rather aggregate opinion of majority of market participants. Also, as agreed before, let’s suppose that aggregate expectations of majority actually moves the market. Thus if today market is on aggregate indifferent regarding the future of say S&P500, situation looks like this:

Drawn at Academo.org

We are at equilibrium. No majority of sellers or buyers prevails, price does not move. However, suppose some positive news come in, which are translated into a positive aggregate signal:

Drawn at Academo.org

Aggregate opinion moves from point one to point two, due to what market goes up, which looks like this:

And then we arrive at the new equilibrium, which once again looks like this:

Drawn at Academo.org

This is all good and easy to understand. Simple economics just depicted in fancy charts. However, when we think in terms of signals, information and such charts, it is easy to understand why and how over time fundamentals are less and less important.

The key here is that to get from the first equilibrium to the second one, the overall underlying opinion needed to change. Thus if we use time axis, situation might look something like this:

Drawn at Academo.org

In the distance there is the first equilibrium. From the perspective of the new equilibrium, the old one seems to be more negative. Not actually, but relatively. Meaning that previously the bullish narrative (or information, or signal) which lead to the new equilibrium was unknown, due to what our future expectations about the market were less positive.

As discussed before, the steepness and height of the surface shows how easy it is to reach a new equilibrium. Meaning that the steeper and higher the walls, the harder it is to move the market to one side or another. The signal, which would form strong enough aggregate expectations, needs to be relatively strong. While if the surface is less steep, it is easier to go into that direction. Thus:

Drawn at Academo.org

From this it is apparent that if everyone is rational, as according to the most strict efficient market hypothesis, both slopes should be equally steep. Meaning that it is equally hard to push majority of market participants towards one side or another.

However, as people are not always rational in the neo-classical sense, what is evident by bubbles and panics, our surface, which we may call the space-time of financial universe, is not always uniformly sloped. As some underlying story, as explained in the previous post, evolves over time and is supported by ad-hoc narratives, the theoretical uniformly sloped space warps due to increasing gravitational effects of the underlying story.

Drawn at Academo.org

As time goes by, surface changes. At first, just after some bubble pops, everyone is afraid to buy. Thus it is harder to push the market upwards. However, as some new story starts to unfold and number of narratives supporting it surface, aggregate expectations shift. Due to that aggregate signals also shift. So prices go up more easily.

After some time, as all the biases and heuristics kick in, every narrative starts to support the underlying story, markets forget what risk or fear is, everyone is quite sure that the only way to go is further up and so bubbles form.

Which burst only when a tremendous story-breaking event occurs. So large that even through all the ignorance and biases it brings the critical mass back to reality. Or, in other words, when external signal is so strong that it simply breaks the underlying story and shows by how much reality is different from that cherry-picked-narrative-based story everyone is telling.

Overall, changes in space-time of financial universe occur due to both:

1)       Personal biases and heuristics – the first level of signaling (as described before);

2)      Aggregate signaling which leads to herding;

The underlying story, despite being true at the beginning, is constantly exaggerated by personal and aggregate decision making fallacies. People are wired so that they will always choose to believe a story which supports their expectations and interests instead of accepting the harsh reality. Especially when all their peers agree with them and the story.