By Dr Frank Shostak
We suggest that what is labelled as financial markets are various individuals engaged in the buying and selling of financial assets. We hold that most of the time the actions of market participants are driven by popular ideas.
If the decisions taken by the market participants are based on a theory which is detached from the facts of reality, then the direction of the market is likely to follow the theory. Conversely, if the market participants were to follow a theory that corresponds to the facts of reality, then the market is most likely going to reflect this.
The employment of theories that are based on assumptions detached from the facts of reality was inspired by the writings of economist Milton Friedman. According to Friedman since it is not possible to establish “how things really work,” then anything goes, as long as the theory can generate accurate forecasts. This means that what matters is not trying to understand how things really work i.e. to understand the economic fundamentals but to have a theory that generates accurate forecasts. But is forecasting capability a valid criterion for accepting a theory?
For instance, all other things being equal, an increase in the demand for bread will raise its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow, or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory as useless because it cannot forecast the future price of bread?
A framework of thinking labelled as the Efficient Market Hypothesis (EMH) using a different reasoning to the one of Friedman also dismisses fundamental analysis arguing that the market adjusts so quickly to information that it is futile paying attention to fundamental analysis. Whatever information this analysis is going to reveal is already contained in asset prices. It follows that there is no point in paying attention to fundamental analysis. A simple policy of random buying and holding will do.
It is hard to imagine that the effect of a particular cause which begins with a few individuals and then spreads over time across many individuals can be assessed and understood instantaneously. For this to be so, it would mean that market participants can immediately assess future consumers’ responses and counter responses to a given cause. This, of course, must mean that market participants not only know consumers’ preferences but also know how these preferences are going to change. However, consumer preferences cannot be revealed before consumers have acted.
Do we know something about ourselves?
Contrary to the popular thinking, economics is not about gross domestic product (GDP), the consumer price index (CPI) or other economic indicators as such, but about human beings that interact with each other.
For instance, one can observe that individuals are engaged in a variety of activities. They may be performing manual work, driving cars, walking on the street or dining in restaurants. The essence of these activities is that they are purposeful.
Furthermore, we can establish the meaning of these activities. Thus, manual work may be a means for some people to earn money, which in turn enables them to achieve various goals like buying food or clothing. Dining in a restaurant can be a means for establishing business relationships. Driving a car may be a means for reaching a particular destination. Or we can say that individuals employing means to achieve ends. That human actions are purposeful also implies that these actions are conscious.
Note the statement that human beings are acting consciously and purposefully cannot be refuted, for anyone that tries to do this does it consciously and purposefully i.e. he contradicts himself. Ludwig von Mises, the originator of this approach labelled it praxeology. Using the knowledge that human beings are acting consciously and purposefully, Mises was able to derive the entire body of economics .
We suggest that this logically based theory can assist in assessing the validity of the popular view that the key driver of the economy is demand. In the market economy, wealth generators do not produce everything for their own consumption. Part of their production is used to exchange for the produce of other producers. Hence, in the market economy, production precedes consumption. This means that something is exchanged for something else. This also means that an increase in the production of goods and services sets in motion an increase in the demand for goods and services. Note that by means of production, the goal i.e. the demand is reached.
Observe that demand is constrained by individual’s ability to produce goods. The more goods that an individual can produce the more goods he can demand i.e. acquire. What enables the expansion of production is the expanding subsistence fund. It follows then that the key driver of the economy is not demand but the subsistence fund, which comprises of saved consumer goods.
Or, for example, to counter an emerging economic slump various experts urge the central bank to increase the pace of monetary pumping. By means of an increase in the money supply growth rate it is held that individual’s wellbeing is going to be protected.
Money however, is not a suitable mean to promote wealth generation as it can only fulfil the role of the medium of the exchange. On the contrary, an increase in the supply of money is going to undermine the wealth generation process.
Focusing on the essence rather than on the multitude of economic indicators
Most financial market participants respond to the multitude of economic data. Thus, if an economic indicator such as GDP is going up then market participants tend to push the stock market higher. Or if price inflation moves up this is perceived as bad news for the financial markets.
We are of the view that rather than reacting to many economic indicators it is better to focus on the essential factor that drives the economy, which is the subsistence fund.
For instance, according to a logically based analysis an analyst has concluded that the subsistence fund is likely to be in trouble. However, this conclusion runs contrary to the stock market direction, which is trending upward. Does it then imply that the analyst should abandon the logical thinking and follow the market?
If one has established that there is a high likelihood that the subsistence fund is in trouble then one should stick to this view. At least one should be aware of a possible economic weakness ahead and the consequent implications to financial markets. Observe, that by ascertaining that the subsistence fund is in trouble, the investor could still consider various short-term strategies that correspond to the view of the majority of the market participants. As time goes by the investor could start exercising a greater caution on account of the likely implications of the decline in the subsistence fund.
Can positive thinking prevent decline in economic activity?
Given the popular view that what drives the economy is demand i.e. demand causes supply, many market participants are of the view that positive thinking is the key for economic growth. Positive thinking and a large dosage of “good” news can prevent the development of pessimistic expectations and in turn bad economic conditions, or so it is held. It is then crucial not to upset this psychology in order to keep the economy prosperous. Hence, whenever economists discuss the state of the economy, they try to portray the bright aspect of it. Even when the economy falls into a recession, various influential commentators are very guarded in their speech.
Again, the main reason for this gentle talk is a view that a soft language will not upset individual’s confidence. If individuals’ confidence is kept stable then stable economic activity will follow, so it is held. We suggest that irrespective of individuals psychological disposition if the facts of reality, identified by a logically based theory, point to a likely economic slump ahead then this is what is likely to emerge.
Conclusion
Contrary to the popular view the market as such does not have a superior knowledge. If the majority of the market participants follow misleading ideas the market is going to display these ideas for a certain period of time until the facts of reality are going to take over.
