by Vadim Pokhlebkin
Updated: November 26, 2014
You may remember that after the 2008-2009 crash, many called into question traditional economic models. Why did they fail?
And more importantly, will they warn us of a new approaching doomsday, should there be one?
The "10 Popular Investment Myths Shattered" series gives you a well-researched answer. Here is the conclusion of our 10-part series.
Conclusion of the "10 Popular Investment Myths" Study
By Robert Prechter (excerpted from the monthly Elliott Wave Theorist; published since 1979)
We have investigated whether one can find any consistent cause of financial market price changes by looking at dramatic events and trying to tie them to market movements.
What if one reverses the investigation to look for dramatic price changes first and then try to fit them to causal events? In their 1989 paper, Cutler, Poterba and Summers investigated just such situations. Starting with days during which stock prices moved dramatically, they scoured the news to find exogenous causes. Their conclusion is stunning:
"...many of the largest market movements in recent years have occurred on days when there were no major news events."
In other words, whenever the stock market was leaping or plummeting on any particular day, there was often no news sufficiently striking to explain it. And it happened regardless of the fact that there is lots of news all the time, providing substantial opportunity for data fitting, which is what financial reporters do at the end of every trading day and what many economists do in their monthly reports.
Perhaps you are thinking that important background conditions are trumping daily events. Surely the two most dramatic price changes of the past century have clear causes. Or do they?
Economists of all stripes have tried to come up with an explanation for the 1987 crash. Yet in a 1991 paper, four years after the fact, William Brock studied economists' commentaries and concluded,
"In my opinion, no satisfactory explanation has been found [for] the most recent crash...Black Monday, October 19, 1987."
What about the most devastating event of the 20th century, the Great Depression and the collapse in stock prices that led to it? The Winter 1999 issue of the Federal Reserve Bank of Minneapolis' Quarterly Review observed,
"Economists and policymakers are still studying and debating what caused this catastrophic economic event." ...
Economists have had eight decades to extract something of value out of their exogenous-cause model, only to find that it offers no useful answers and no explanation upon which its proponents can agree. Remember, we are not even asking economists of the time to have predicted the event. As history reveals, the opposite occurred; the most famous economists assured the public that nothing of the kind was on the horizon, that the economy had reached "a permanent plateau." Considering that we seek only a retrospective explanation from this report, a more damning indictment of the exogenous-cause paradigm could hardly be imagined.
When you are brilliant, your mind is rational, your logic is sound, and yet your conclusions are continually wrong or inadequate, there is only one explanation: Your premise is false.
We have shown that the phrases "interest-rate shock," "oil-price shock," "trade-balance shock," "earnings shock," "GDP shock," "war shock," "peace shock," "terrorism shock," "inflation shock" (and therefore "deflation shock"), "monetary shock" and "fiscal shock" have no value (and in my view not even any meaning) when it comes to analyzing the behavior of financial markets. There must be something wrong with the premise behind these terms.
To summarize our findings up to this point:
1) No type of exogenous event leads to a consistent result in financial market movement.
2) The biggest stock market movements have no clear exogenous causes even in retrospect.
3) There are no consistent correlations or relationships between supposed exogenous causes and market results.
Why the Failure of Exogenous Causality Is Not Often Apparent to Most Observers
Most of the time, the stock market rises and the economy expands. During such times, economists confidently cite half a hundred various exogenous causes to explain the growth that is occurring. Even though the explanations are either tautological ("the increase in jobs has fueled a pickup in GDP") or bogus (and refutable in every case by showing a single historical graph), no discernible cognitive dissonance occurs among economic theoreticians or practicing economists and their clients. All these people feel comfortable, so they accept the adequacy of the explanations and demand no evidence.
But when people are uncomfortable, they begin to seek valid explanations, which do require some evidence. People are uncomfortable during bear markets and economic contractions, so this is when they actually bother to investigate economists' theories, methods and explanations.
At such times, the theories, methods and explanations are always found wanting. They are just as wanting when times are good, but during such times no one bothers to check.