A new way to explain the markets

Marketplace Staff Oct 1, 2009
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A new way to explain the markets

Marketplace Staff Oct 1, 2009
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TEXT OF INTERVIEW

Kai Ryssdal: The Dow Industrials fell more than 200 points today. Crude prices slipped just a little bit. I think hog futures were off as well. I’m not going to stand here and try to explain why. But the fact is we don’t really know why the markets do anything. The last year-and-a-half have given lie to what was once the dominant idea for how the markets worked. Something called the Rational Markets theory. So now economists are looking for a new way to explain why markets do what they do. Here to explain it to us is John Authers. He’s the investment editor at the Financial Times. Mr. Authers, good to have you with us.

JOHN AUTHERS: Well, it’s a pleasure to be here.

Ryssdal: We had thought for 40 or 50 years that we had a pretty good handle on how the markets worked, didn’t we?

AUTHERS: Yes. In the early 1950s there was a series of big breakthroughs in academic economics, a number of which got rewarded with Nobel prizes, which left us thinking that we knew that stocks were the best investment for the long run and that everything did seem to be very clear.

Ryssdal: Until it got very unclear the past year-and-a-half or so. What the heck happened?

AUTHERS: Well, it wasn’t so much unclear as total unequivocal refutation of all that we had held dear. I mean there were certain parts of efficient markets that everybody knew were always an obstruction. Stock market moves up, completely random. Everybody knows that occasionally you get into big bubbles, and occasionally you get into big busts. I think the single biggest problem that you had last year was that everything was built around this very highfalutin notion of diversification, which is a more complicated way of saying “don’t put all your eggs into one basket, spread your risks around.” So people invested in far beyond the stock market, in bonds, commodities, and they all went down together. What people discovered they had done was in fact make the same bet many times over when they thought they were spreading their risks, and that means that the investment industry is really without a rudder at this moment. The means by which they navigated through risk and return are obviously not working anymore.

Ryssdal: As they grope around for a new rudder, a new steering mechanism, what kinds of ideas are they throwing up on the wall and seeing if it sticks?

AUTHERS: One of the ideas is to look in terms of risks, as opposed to asset classes. The different asset classes may actually be exposed to exactly the same risk, so you need to look at what you’re scared of, and then try to work out how different asset classes would respond, rather than simply thinking if I’ve got 60 percent in stocks then I can put the rest of my portfolio into bonds, and I’ll be fine. If you have an event that happens that causes both of them to go down together, you haven’t helped yourself. Now the other key thing about ideas, and there are various other variations of the theme going around, is people now accept you’re not going to get a clear mathematical number at the end. You do not have my risk equals x at the end of this. We need to make much more room for human judgment.

Ryssdal: You have this great line actually in the article you wrote in the paper on this the other day. You say that economists and these investor guys, they all have what you call physics envy. They want this clear formulaic definition and be able to plug numbers in and come out with a result. So why do we need a theory? Why can’t we just let the markets do what markets do, which is just sort of go about their daily thing?

AUTHERS: The markets are too important to leave that way. We have in the last half-century or so entrusted all kinds of things to markets that were previously left to human judgment. For example, money-market funds have taken over some of the functions of banks. The commodity markets at one point were left to specialists who actually knew about the economics of pulling oil out of the ground. Now that is much more left to financial markets. At one point maybe we could have just left markets to go their own pretty way. The genie is out of the bottle now. I don’t think we can do that. Whether we can analyze them with the kind of precision we’d like to, it may well mean that you need to go into the kind of real esoteric ideas about chaos and turbulence that physicists haven’t been able to apply to thermodynamics yet. Whether we’ll be able to is another matter, but I do think that we have to try.

Ryssdal: John Authers is the investment columnist the Financial Times. Thanks so much for your time.

AUTHERS: Thank you.

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