Two Rival forms of Rationality Constitute a Dilemma

It is crucial to the "science" of economics that persons act "rationally" ~ that is that they calculate what means will bring about particular ends and do so accurately by predicting and controlling the output they desire. But suppose there were two forms of this rationality and that these were in conflict? Suppose that you could profit from two different kinds of calculation but that these grossly interfered with each other? This might put some of the cleverest people in our economy into a quandary. In the current financial crisis I believe this has occurred. The conventional view, not untrue, is that financial analysts engage in a "Fair Value strategy". Typically specialising by industry, they find out everything they can about a particular company, not just its past record but its future prospects, and advise their clients to buy what is undervalued and sell what is overvalued.

It is beyond dispute that this is done and often done well. The more transparent is a company the more intelligent the analysis. What we have is literally hundreds of expert verdicts which aggregate and balance each other out. If this was the only kind of rationality being exercised we could not explain the volatility of markets. They would change smoothly over time. Something else is happening to account for sudden peaks and troughs with stocks and properties first ludicrously over valued and then dumped in something akin to a panic. There are far too many of these market collapses since the 1944 Bretton Woods agreement for this to be coincidental. The latest one is the most severe but has many precedents. Something is obviously wrong, but what?

What seems to have happened is that an entirely different rationality has come into play. This has been referred to as Momentum Strategy. It is less a verdict upon the intrinsic value of shares or debt obligations than a view of what other people now believe and will do in regard to these shares. You are no longer seeking truth but sampling opinions.

If a bull market is running then prices could continue to climb, regardless of the analyst's conviction that many stocks are overpriced and that a correction must come. How does an analyst behave when one form of reason tells him to sell and another tells him to buy because the market has not yet peaked? Clearly s/he will be conflicted? Riding the momentum of the market is clearly desirable because there is money to be made on the upside and also on the downside by selling short. Moreover a volatile market is one good reason professional help is sought and paid for. Most derivative products are protections against volatility.

We know from marketing studies that when information about competing products becomes complex and hard-to-compare that buyers ask their friends and often follow their advice. A trader or analyst with doubts about the value of a property may still "follow the market" in the belief that it might know better. Professional gamblers on a race-course will often follow a sudden large bet, on the grounds that connections to that stable know something and are hazarding their own funds.

Even if the analyst believes the market has been stampeded in an irrational manner s/he may conclude that money can be made from a good reading of a herd instinct. In this event private doubts vie with public confidence and the dilemma sharpens to the point of acute nervousness. There is an obvious reason why analysts cannot ignore market euphoria. They will lose money for clients if during a boom they cry warnings and apply brakes. A doomsayer is unpopular even ridiculous as the market climbs. Advice given by the company's experts is compared by their managers to the Dow Jones Average and beware the traders who fall behind the average of a booming market. By the time the correction comes their jobs are lost! Momentum investing is short-term expedient.

Consider the agonised state of mind among analysts as markets peak. On the one hand nearly all the share prices they have analysed are seriously over valued by one kind of logic but may still have some gains to make by a second kind of logic. What are they to do? It is as if they were poised on the edge of a high cliff. The fall when it comes will be steep but when will it come? Under such a mindset even a small correction can trigger a panic as all head for the exit simultaneously shouting "sell!" Everyone has long believed that every one else was an idiot and each is in full flight from the crazed mob.

Below we have modelled this process in three dimensions using Catastrophe Theory, a scientific systems theory of Rene Thom. A square piece of paper has two adjoining edges. a -----c represents Fair Value Strategy and a----b represents Momentum Strategy. Take any piece of square or rectangular paper and elevate the top edge a---b while lowering the bottom edge a----c. When you do this, using your own hands, a cusp will appear in the middle of the paper, which blocks the path to the top right-hand corner where these strategies might have been reconciled but for over reliance on short-term momentum. As it is a precipice confronts you over which thousands are tipped as panic grips them and "greed" gives way to "fear". The lower of the two surfaces renders the higher, on two dimensions rather than three. When we do this a "Bifurcation Set" opens up like a chasm on which no player can stand since it represents collapse, "the fall of man" if you will. Players are thrown from X to Y in a sudden volatile crash.

(please come back tomorrow for Charles' next briefing)