How financial markets work today

Nobel laureate @robertshiller wrote an article in NY Times this weekend about the uncertainties of what will happen if the fed hikes interest rates in December, as is widely expected. He mentions that humans don’t behave like computers. In his previous works, he makes an awesome nobel-prize-winning case that emotional responses have shaped the evolution of markets and the economy much more than logical textbook economics.

I am a big believer in behavioral economics and, excluding students in his courses, I might be among the top hundred avid readers on this topic. However, I am not sure it applies to the scenario Mr. Shiller is talking about.

As I understand it, @robertshiller is saying that there are so many possible consequences of Fed’s action, that most market participants will figure out how the fed hike affects them AFTER it happens.

This nonconsequentialist reasoning paper is a seminal work done by Amos Tversky and Eldar Shafir on this subject.

This is how markets work today in my opinion.

There are two things that portolio managers do about the future, (1) try to predict some parts of it (2) contain the risk against all the parts they could not predict well. While a 0.25% hike will not by itself shake the floor, since it has been the most talked about Fed action for the last five years, I am fairly certain that most financial institutions would have measured and contained their risk to it.

Now let’s look at (1) “try to predict some parts of it”. I conjecture that market participants behave like content marketing people. They find a claim about the future and some reason for that scenario to appear plausible. They take a position to profit from that scenario and publish the content. If the claimed reasoning happens to find more converts, they ( and others ) pile onto the trade and take it as far as it can go. If it fails to gather enough “likes”, then they unwind the trade, hopefully without much loss. All of this could be happening in microseconds, for a high frequency trader, or over a few years, for a macro fund. The content could range from trades and orders and messages, for a high frequency firm, to interviews and research papers and client letters for a long-term portfolio manager. The participants of this drama are traders, investors, financial news sources, opinion columns and central bankers too.

While most other actors profit from finding a hot story early, the fed has adopted a clear mandate these last few years … to be consistent, reliable and predictable. These are three words, that every parent would have heard about good parenting.

That’s why I think that when, and if, the Fed hikes rates by a tiny 25 basis points in December, investors and their representatives will have done a fair bit of thinking of what could happen. That notwithstanding, many actors will try to light up twigs and hope to grow them into fires in different parts of the market, and the Fed will consistently keep dousing away every flame that becomes large enough.

ps: @robertshiller please forgive me if I did not get the point of the article. I loved your newest book, Phishing for Phools: The Economics of Manipulation and Deception by the way.