feb 2010 ewt

February 2010 issue© February 19, 2010

THE SOCIONOMIC THEORY OF FINANCE, PART 1:THE CONVENTIONAL ERROR OF EXOGENOUS CAUSE AND RATIONAL REACTION

Every time there is a recession, observers grumble about economists’ methods. The deeper the recession carries, the louder the grumbling. The reason that widespread complaints occur only in recessions is that economic forecasters as a group never, ever anticipate macroeconomic changes. Their tools don’t work, but consumers of their commentary do not notice it until recessions occur, because that is the only time when everyone can see that the methods failed. The rest of the time, when expansion is the norm, no one notices or cares.

Ironically, in the long run, the complaints never stick. Once the economy begins expanding again, everyone forgets about their old complaints. The media resume quoting economists, despite their flawed methods, and they are once again satisfied that their commentaries make perfect sense. There is a good reason for this recurring behavior. At the end of this exposition, we will explore why it happens, over and over, and why it probably will never cease.

The recent/ongoing economic contraction is the deepest since the 1930s, so the complaints about economists’ ideas are the most strident since that time. Figure 1 shows how one publication expressed this feeling following four quarters of negative GDP (and just before the recent partial recovery began).

The rebound in the economy since July has brought a collective sigh of relief from the economics profession. Yet the bankruptcy of conventional methods for predicting trends in the macro-economy has not gone away. Even in this cycle, it has only begun to manifest.

Economists polled by USA Today and The Wall Street Journal are back to normal, which is to say unanimously optimistic, for at least a full year ahead. When these optimistic forecasts fail yet again and the bear market and depression deepen, economists will find themselves even more on the defensive. Critics’ complaints will become even louder. By the bottom, everyone will agree that economic theory is worthless. Then, in the recovery, everyone will go back to using it again.

Nevertheless, this brief time of doubt and criticism affords socionomics an opportunity to be heard. People listen only when they are emotionally attuned to alternative ideas, and we have such a time now.

On January 6, 2010 appeared an article titled, “Economists Debate Why They Blew It.” (Kanell, Michael E., AJC, 1/6/10; www.elliottwave.com/wave/economists-debate) Three comments stand out in that article:

Given that no mainstream economist predicted the economic havoc that has occurred over the past two 1. years, the article says, “Now economists debate whether they lacked the right tools or needed a different perspective.” The answer is: both.

A Nobel-prize winning economist is quoted as saying, “2. Virtually no one saw…how fragile the system had become.” The key word here is virtually. A handful of macroeconomic observers did see it coming. What were their tools and perspectives? Shouldn’t the profession investigate and test their methods and, if proved out, adopt them?

Robert Shiller of Yale rightfully states, “We want to have a 3. beautiful and elegant model.” Yes, we do.

Figure 1

The multi-part series that begins below expands upon a speech given to faculty and graduate students at the Judge Business School, Cambridge University, on February 9, 2010.

This issue was posted February 19.Avoid mail delay: get The Elliott Wave Theorist instantly on-line; call customer service at 800-336-1618.

http://www.elliottwave.com/wave/economists-debate

The Elliott Wave Theorist—February 19, 2010

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For over 30 years, I have argued that the socionomic model of social causality is not only beautiful and elegant but also true. A subset of socionomics, the socionomic theory of finance (STF), is consistent with empirics, and to the extent of our ability as theoreticians, internally consistent as well. Other theories of finance fail on one or both grounds. This series will provide an overview of STF so that you can judge these aspects for yourself.

Few people are able to find socionomic theory accessible until they first see that their old way of thinking is flawed. So we will begin with a look at the reigning ideas, which are based on mechanistic causality, to which most humans naturally default, even in the social realm.

The Fundamental Flaw in Conventional Financial and Macroeconomic TheoryConventional financial theory relies upon the related and seemingly sensible—indeed seemingly imperative—

ideas of exogenous cause and rational reaction. In a limited but comprehensive survey, we find that modern academic papers, studies, hypotheses and theories about social motivation—in the fields of finance, economics, politics, history and sociology—begin with these ideas, whether they are stated explicitly or not.

Most of the time, these ideas are stated explicitly. Papers are packed with discussions of and conjecture about “information flows,” “exogenous shocks,” “fundamentals,” “input,” “catalysts” and “triggers.” Even hypotheses that make room for mass psychology embrace ideas such as “positive feedback loops” under the assumption that even if social mood were to turn on its own accord, resulting events have the power to reinforce social mood and, more narrowly in the realm of finance, to affect aggregate investors’ buying and selling decisions. Papers on behavioral finance that describe non-rational behavior nevertheless treat it as an exception or departure from rationality, objectivity, utility maximization and market equilibrium, all of which are characteristic of the exogenous-cause/rational-reaction paradigm. This paradigm is accurate and useful in microeconomics but inaccurate and useless in fields of finance or so-called macroeconomics (which as I hope to show is really a subset of socionomics).

The Efficient Market Hypothesis (EMH) and its variants in academic financial modeling as well as the entire profession of applied economics rely at least implicitly but usually quite explicitly upon the bedrock ideas of exogenous cause and rational reaction. Stunningly, as far as I can determine, no evidence supports these premises, and, as the discussion below will show, all the evidence that we socionomists have investigated contradicts them. Later in this exposition I hope to show that every proposed relationship that fails under an exogenous-cause explanation becomes a success when given a socionomic explanation.

Refuting Exogenous CausalityEMH argues that as new information enters the marketplace, investors revalue stocks accordingly. If this were

true, then the stock market averages would look something like the illustration shown in Figure 2. In such a world, the market would fluctuate narrowly around equilibrium as minor bits of news about individual companies mostly canceled each other out. Then important events, which would affect the valuation of the market as a whole, would serve as “shocks” causing investors to adjust prices to a new level, reflecting that new information. One would see these reactions in real time, and investigators of market history would face no difficulties in identifying precisely what new information caused the change in prices.

Our idealized example shows what, under this model, would be the effects of a sudden slew of bad earnings reports, an unexpected terrorist attack with implications for many more to come, a large government “economic stimulus” program, a major contraction in GDP, a government program to bail out at-risk banks, a declaration of peace after a time of war and a significant decline in interest rates. Surely such events would—rationally and objectively—effect a change in stock prices, at least temporarily.

Figure 2


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This is a simple idea and simple to test. But almost no one ever bothers to test it.According to the mindset of conventional economists, no one needs to test it; it just feels right; it must be right.

It’s the only model anyone can think of. But socionomists have tested this idea multiple ways. And the result is not pretty for the theories that rely upon it.

The tests that we will examine are not rigorous or statistical. Our time and resources are limited. But in refuting a theory, extreme rigor is unnecessary. If someone says, “All leaves are green,” all one need do is show him a red one to refute the claim. I hope when we are done with our brief survey, you will see that the ubiquitous claim we challenge is more akin to economists saying “All leaves are made of iron.” We will be unable to find a single example from nature that fits.

Testing Exogenous-Cause Relationships from Economic EventsClaim #1: “Interest rates drive stock prices.”

This is a no-brainer, right? Economic theory holds that bonds compete with stocks for investment funds. The higher the income that investors can get from safe bonds, the less attractive is a set rate of dividend payout from stocks; conversely, the less income that investors can get from safe bonds, the more attractive is a set rate of dividend payout from stocks. A statement of this construction appears to be sensible. And it would be, if it were made in the field of economics. For example, “Rising prices for beef make chicken a more attractive purchase.” This statement is simple and true. But in the field of finance such statements fly directly in the face of the evidence. Figure 3 shows a history of the four biggest stock market declines of the past hundred years. They display routs of 54% to 89%. In all these cases, interest rates fell, and in two of those cases they went all the way to zero! In those cases, investors should have traded all their bonds for stocks. But they didn’t; instead, they sold stocks and bought bonds. What is it about the value of dividends that investors fail to understand? Don’t they get it?

As in most arguments from exogenous cause (an observation made, as far as I know, for the first time in The Wave Principle of Human Social Behavior), one can argue just as effectively the opposite side of the claim. It is just as easy to sound rational and objective when saying this: “When an economy implodes, corporate values fall, depressing the stock market. At the same time, demand for loans falls, depressing interest rates. In other words, when the economy contracts, both of these trends move down together. Conversely, when the economy expands, both of these trends move up together. This thesis explains why interest rates and stock prices go in the same direction.” See? Just as rational and sensible. On this basis, suddenly the examples in Figure 3 are explained. And so are the examples in Figure 4. Right?

No, they’re not, because, as the first version of the claim would have it, there in fact have been plenty of times when the stock prices rose and interest rates fell. This was true, for example, from 1984 to 1987, when stock prices more than doubled. And

Figure 3


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there have been plenty of times when stock prices fell and interest rates rose, as in 1973-1974 when stock prices were cut nearly in half. Figures 5 and 6 show examples. So you can’t take the equally sensible opposite exogenous-cause argument as valid, either. And you certainly cannot accept both of them at the same time, because they are contradictory.

At this point, conventional theorists might try formulating a complex web of interrelationships to explain these changing, contradictory correlations. But I have yet to read that any such approach has given any economist an edge in forecasting interest rates, stock prices or the relationship between them.

To conclude, sensible-sounding statements about utility-maximizing behavior (per the first explanation) and about mechanical relationships in finance (per the second explanation) fail to capture what is going on. Events and conditions do not make investors behave in any particular way that can be identified. Economists who assert a relationship (1) believe in their bedrock theory and (2) never check the data.

Claim #2: “Rising oil prices are bearish for stocks.”This is a ubiquitous claim. It would take weeks to collect all

the statements that economists have made to the press to the effect that recently rising oil prices are “a concern” or that an unexpected (they’re always unexpected) “oil price shock” would force them to change their bullish outlook for the economy. For many economists, the underlying assumption about causality in such statements stems from the experience of 1973-1974, when stock prices went down as oil prices went up. That particular juxtaposition appeared to fit a sensible story of causation regarding oil prices and stock prices, to wit: Rising oil prices increase the cost of energy and therefore

Figure 4

Figure 5

Figure 6


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reduce corporate profits and consumers’ spending power, thus putting drags on stock prices and the economy.

Figure 7 shows, however, that for the past 15 years there has been no consistent relationship between the trends of oil prices and stock prices. Sometimes it is positive, and sometimes it is negative. In fact, during this period it has been positive for more time than it has been negative! And the quarters during this period when the economy contracted the most occurred during and after the oil price collapse of 2008. Thereafter oil prices doubled as the economy was reviving in 2009. None of this activity fits the accepted exogenous-cause argument.

But wait. Could rising oil prices perhaps be bullish for stocks? Yes, once again we can argue both sides of the exogenous-cause case. Consider: As the economy begins to expand, business picks up, so stock prices rise; and as business picks up, demand for energy rises as businesses gear up and operate at higher capacity. That’s why stocks and oil go up together. Makes sense, doesn’t it?

But neither claim explains the data. Sometimes oil and stocks go up or down together, and sometimes they trend in opposite directions. As with Figures 3-6, we could easily isolate examples of all four pairs of coincident trends. To conclude, we can determine no consistent relationship between the two price series, and no economist has proposed one that fits the data.

This graph negates all the comments from economists who say that an “oil shock” would hurt the stock market and the economy. It also throws into doubt the very idea that stock prices and oil prices are linked.

Claim #3: “An expanding trade deficit is bad for a nation’s economy and therefore bearish for stock prices.”Over the past 30 years, hundreds of articles—you can find them on the web—have featured comments from

economists about the worrisome nature of the U.S. trade deficit. It seems to be a reasonable thing to worry about. But has it been correct to assume throughout this time that an expanding trade deficit impacts the economy negatively?

Figure 8 answers this question in the negative. In fact, had these economists reversed their statements and expressed relief whenever the trade deficit began to expand and concern whenever it began to shrink, they would have accurately negotiated the ups and downs of the stock market and the economy over the past 35 years. The relationship, if there is one, is precisely the opposite of the one they believe is there. Over the span of these data, there in fact has been a positive—not negative—correlation between the stock market and the trade deficit. So the popularly presumed effect on the economy is 100% wrong. Once again, economists who have asserted the usual causal relationship neglected to check the data.

It is no good saying, “Well, it will bring on a problem eventually.” Anyone who can see the relationship shown in the data would be far more successful saying that once the trade deficit starts shrinking, it will bring on a problem. Whether or not you assume that these data indicate a causal relationship between economic health and the trade deficit, it is clear that the “reasonable” assumption upon which most economists have relied throughout this time is 100% wrong.

Figure 7

Figure 8


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Around 1998, articles began quoting a minority of economists who—probably after looking at a graph such as Figure 8—started arguing the opposite claim. Fitting all our examples so far, they were easily able to reverse the exogenous-cause argument and have it still sound sensible. It goes like this: In the past 30 years, when the U.S. economy has expanded, consumers have used their money and debt to purchase goods from overseas in greater quantity than foreigners were purchasing goods from U.S. producers. Prosperity brings more spending, and recession brings less. So a rising U.S. economy coincides with a rising trade deficit, and vice versa. Sounds reasonable!

But once again there is a subtle problem. If you examine the graph closely, you will see that peaks in the trade deficit preceded recessions in every case, sometimes by years, so one cannot blame recessions for a decline in the deficit. Something is still wrong with the conventional style of reasoning.

Claim #4: “Earnings drive stock prices.”This belief powers the bulk of the research on Wall Street. Countless analysts try to forecast corporate earnings

so they can forecast stock prices. The exogenous-cause basis for this research is quite clear: Corporate earnings are the basis of the growth and the contraction of companies and dividends. Rising earnings indicate growing companies and imply rising dividends, and falling earnings suggest the opposite. Corporate growth rates and changes in dividend payout are the reasons investors buy and sell stocks. Therefore, if you can forecast earnings, you can forecast stock prices.

Suppose you were to be guaranteed that corporate earnings would rise strongly for the next six quarters straight. Reports of such improvement would constitute one powerful “information flow.” So, should you buy stocks?

Figure 9 shows that in 1973-1974, earnings per share for S&P 500 companies soared for six quarters in a row, during which time the S&P suffered its largest decline since 1937-1942. This is not a small departure from the expected relationship; it is a history-making departure. Earnings soared, and stocks had their largest collapse for the entire period from 1938 through 2007, a 70-year span! Moreover, the S&P bottomed in early October 1974, and earnings per share then turned down for twelve straight months, just as the S&P turned up! An investor with foreknowledge of these earnings trends would have made two perfectly incorrect decisions, buying near the top of the market and selling at the bottom.

In real life, no one knows what earnings will do, so no one would have made such bad decisions on the basis of foreknowledge. Unfortunately, the basis that investors did use—and which is still popular today—is worse: They buy and sell based on estimated earnings, which incorporate analysts’ emotional biases, which are usually wrongly timed. But that is a story we will tell later. Suffice it for now to say that this glaring an exception to the idea of a causal relationship between corporate earnings and stock prices challenges bedrock theory.

Claim #5: “GDP drives stock prices.”Surely the stock market reflects the nation’s Gross Domestic Product. The aggregate success of corporations

shows up as changes in GDP. Stocks are shares in corporations. How could their prices not reflect the ebb and flow of GDP?

Suppose that you had perfect foreknowledge that over the next 3¾ years GDP would be positive every single quarter and that one of those quarters would surprise economists in being the strongest quarterly rise in a half-century span. Would you buy stocks?

If you had acted on such knowledge in March 1976, you would have owned stocks for four years in which the DJIA fell 22%. If at the end of Q1 1980 you figured out that the quarter would be negative and would be followed by yet another negative quarter, you would have sold out at the bottom.

Figure 9


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Suppose you were to possess perfect knowledge that next quarter’s GDP will be the strongest rising quarter for a span of 15 years, guaranteed. Would you buy stocks?

Had you anticipated precisely this event for 4Q 1987, you would have owned stocks for the biggest stock market crash since 1929. GDP was positive every quarter for 20 straight quarters before the crash and for 10 quarters thereafter. But the market crashed anyway. Three years after the start of 4Q 1987, stock prices were still below their level of that time despite 30 uninterrupted quarters of rising GDP.

Figure 10 shows these two events. It seems that there is something wrong with the idea that investors rationally value stocks according to growth or contraction in GDP.

Interest rates, oil prices, trade balances, corporate earnings and GDP: None of them seem to be important, or even relevant, to explaining stock price changes. But you need not trust your own eyes. In a study that is stunning for its boldness in actually checking basis premises, Cutler, Poterba and Summers in a paper for the Journal of Portfolio Management in 1989 investigated the effect of economic news on stock prices and concluded, “Macroeconomic news bearing on fundamental values…explains only about one fifth of the movement in stock prices.”

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Even here, I would question the conclusion that such news “explains” even 1/5 of the movement in stock prices. Surely a set of football statistics could generate a 1/5 correlation to the S&P. And every correlation, to have meaning, must have a theory to account for it. What theory accommodates the idea that macroeconomic fundamentals explain 1/5 of stock price changes? If there is no accommodating theory, then the presumed causality involved is tenuous at best.

If the stock market is not reflecting macroeconomic realities, what else could it possibly be doing? Well, how about political news? Maybe political events trump macroeconomic events.

Testing Exogenous-Cause Relationships from Political EventsIt is common for economists to offer a forecast for the stock market yet add a caveat to the effect that “If a war

shock or terrorist attack occurs, then I would have to modify my outlook.” For such statements to have any validity, there must be a relationship between war, peace and terrorist attacks on the one hand and the stock market on the other. Surely, since economists say these things, we can assume that they must have access to a study showing that such events affect the stock market, right? The answer is no, for the same reason that they do not check relationships between interest rates, oil prices or the trade balance and the stock market. The causality just seems too sensible to doubt.

Claim #6: “Wars are bullish/bearish for stock prices.”Observe in the form of this claim that you have a choice for the outcome of the event. Recall my point that you

can argue either side of an exogenous-cause case. Economists have in fact argued both sides of this one. Some have held that war stimulates the economy, because the government spends money furiously and induces companies to gear up for production of war materials. Makes sense. Others have argued that war hurts the economy because it diverts resources from productive enterprise, not to mention that is usually ends up destroying cities, factories and capital goods. Hmm; that makes sense, too. Apparently the way that a war would change an economist’s stock-market outlook depends upon which version of the exogenous-cause argument he believes.

Figure 10


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I will not take sides here. We can negate both cases just by looking at a few charts. Figure 11 shows a time of war when stock values rose, then fell; Figure 12 shows a time of war when they fell, then rose; Figure 13 shows a time when they rose throughout; and Figure 14 shows a time when they fell throughout. Who wins the war seems to mean little, either. A group of Allies won World War I as stock values reached 14-year lows; and nearly the same group of Allies won World War II as stock values neared 14-year highs. Given such conflicting relationships, why and how, exactly, does an economist expect war to affect his economic forecasts?

Claim #7: “Peace is bullish for stocks.”

Most people would not argue that peace is bearish for stock prices. It would seem logical to say that peace allows companies to focus on manufacturing goods, providing services, innovation and competition, all of which helps the overall economy. But does peace in fact have anything to do with determining stock prices?

F i g u r e 1 5 provides an example of peaceful times—the 1920s—in which stock prices seemingly benefited. After all, they rose 500% in just eight

Figure 11

Figure 14

Figure 12

Figure 15 Figure 16

Figure 13


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years, as there was mostly peace around the globe.Figure 16, however, shows that in the time immediately

following, stock prices lost 89% of their value. During this time as well, there was mostly peace around the globe. Yet stock prices fell more in under three years than they had gained in the preceding eight years! It seems that we cannot count upon any consistent relationship between peace and stock prices, either.

Claim #8: “Terrorist attacks would cause the stock market to drop.”

I assume this is what economists mean when they say that something unexpected such as a terrorist attack would cause them to re-evaluate their stock market forecasts. At least, I doubt they mean that a terrorist attack would cause them to revise their estimates upward. It seems logical that a scary, destructive terrorist attack, particularly one that implies more attacks to come, would be bearish for stock prices.

Take a moment to study Figure 17. Surely all of these exceptionally dramatic swings in the DJIA must have been caused by equally dramatic news: bad news at each of the peaks and good news at each of the bottoms. At least that’s what the exogenous-cause model would have us believe.

As it happens, there was indeed a lot of dramatic news during this time. For one thing, there were surprise terrorist attacks on U.S. soil, first the “9/11” attack on the World Trade Center and the Pentagon and secondly the slew of mailings of deadly anthrax bacteria, which killed several people, prompted Congress to evacuate a session, and caused havoc lasting months. Where on the graph of stock prices would you guess all these events have happened?

If you guessed “six trading days from a major bottom and all through a six-month rally,” you would be correct. But if you are an exogenous-cause advocate, you would not have made that guess.

Figure 18 notes these occurrences. The 9/11 attack occurred more than halfway through a dramatic price decline and only six trading days from its end. Afterward, despite deep concerns that more such attacks were in the works, the stock market rallied for six months. The first anthrax attack occurred on the very day of the low for the year, and the attacks, deaths and scares continued throughout the strongest rally on the entire graph. To put it more starkly, the market bottomed when they started and topped out as soon as people realized they were over. If one were to insist upon a causal relationship, one would be forced to conclude that anthrax attacks are bullish for the stock market.

This kind of perverse conclusion is what we invariably reach when examining an exogenous-cause case along with actual data pertaining to it. This is why economists after World War II (see Figure 12) decided that wars were good for the economy. Figure 18 has similar implications for public policy. Should we encourage crazed people to send deadly packages in order to get the stock market to go up? This idea is no dumber than advocating war to get the economy rolling. But the evidence for it is right there, just as it was for the supposed “oil shock” of 1973.

We have uncovered at least one irrefutable fact: Terrorist attacks do not make the stock market go down. The

Figure 17

Figure 18


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assumption behind economists’ repeated implications that terrorist attacks would constitute an “exogenous shock” that would serve to drive down stock prices is shown to be completely wrong.

Apparently political events and conditions, like economic events and conditions, have no consistent causal relationship to the rise and fall of stock prices. Happily, we are not entirely alone in making this observation. In the aforementioned 1989 paper, authors Cutler, Poterba and Summers concluded, “There is a surprisingly small effect [from] big news [of] political developments…and international events.”

1 That is indeed the case. But it is “surprising”

only to devotees of the exogenous-cause paradigm, which means virtually everyone. Proponents of socionomic causality and the Elliott wave model of financial price change are not surprised in the least.

Coming issues of The Elliott Wave Theorist will expand upon this theme and explain the socionomic theory of finance.

CURRENT MARkETSThe Elliott Wave Theorist joined EWFF in focusing intently upon financial markets in the second half of 2009

through January 2010. The major turns that we forecasted appear to have occurred, so there is little point in a detailed review at this time. The dollar has been soaring since November, and all other financial markets have been turning down, one by one. The stock market probably peaked in Minor wave 2 today. The next issue of The Elliott Wave Financial Forecast is already in the works and will cover all these markets when it comes out next Friday.

NOTE1 Cutler, David M., James M. Poterba, and Lawrence H. Summers. “What Moves Stock Prices?” Journal of Portfolio

Management, 15, 3, Spring, (1989), pp. 4-12.

feb 2010 ewt

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