Puzzle: War Expectations.

I try to be skeptical of behavioral finance. I know stock markets are made of people and people have cognitive biases, especially when it comes to making market decisions; however people plays roles and the roles of the traders and analysts are to act as economic rationality calculators, and that rationality is controlled tightly through educational apparatus and institutional situations. (I’m speaking specifically of stock markets here, not you ordering dinner or at the mall.) I think limits to arbitrage born out of risk/reward and market structures are a good first model in causing bubbles and prices anomalies (which you could argue is behavioral, but that’s another thing); I also think the “heads-I-win/tails-you-lose” that is manifest in a lot of the rewards structure of our post-industrial economy can make managers look like they are acting irrationally.

That said, I think it’s important to look at stock puzzles in a lot of different ways, using all our tools. And I have a new puzzle! Here are two facts:

(a) On July 12th 2008, following word that Iran launched a missile that could hit Israel and that the U.S. was considering military action, oil prices jumped around $4.
(b) On December 3rd 2007, a NIE report was released that said that Iran had stopped its nuclear program in 2003, and the Bush team knew that for some time, making experts think that a war with Iran was not likely. It was a genuine news event, and the price of oil didn’t really go down at all, but let’s say it went down around 10 cents (which may have been noise).

When the likelihood of a conflict between the US and Iran goes up, oil goes up a lot, but when the likelihood of a conflict goes down, the price barely goes down. Why the difference?

1) Markets are efficient, and good news has diminished returns for future earnings while bad news grows the net loss exponentially.
2) Markets are behavioral in the sense that they overreact to certain types of news (bombs going off in the Middle East, photos of rockets in a desert) and under react to other kinds of news (the absence of an event happening).
3) To whatever extent markets are capable of processing large amounts of financial, accountancy, and macroeconomics data, they simply don’t have the expertise/time to try and work out a general free-floating risk factor in political relations across countries. Such a measure may be meaningless anyway.
4) The market knew that the NIE report would have no effect whatsoever on Bush’s policy to Iran.
5) Due to so much chaos in the market for oil, it is reasonable that Iran, as a producer of oil, would try and make the market more chaotic through its actions. As such, there is more uncertainty in the future.
6) The market for oil is controlled by “animal spirits” at this point, and people are bidding on it, at the margins, based on any noise that comes across the channel.

More to the point, see how difficult it is to tell the difference between rational/irrational? Between 1&2, and 5&6? The conflict between 3&4? What was rational and what wasn’t will only be decided in retrospect, and that’s a whole other ballpark of bias. Anyway, I’d be curious if anyone has better explanations than the hodgepodge I put up there for the difference between the two.

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5 Responses to Puzzle: War Expectations.

  1. ginandtacos says:

    When an extraordinarily well-known political scientist came to campus to give a talk about the “political markets” (those online “stock” things for elections) it was very hard for me to be cordial when pointing out how stupid the entire concept is.

    He used the phrase “markets are rational” about 30 times, which is approximately retarded. Yes, you have constructed rational explanations for how the market is behaving with regards to news about Iran, the NIE, etc. But we must be very careful to avoid cherry-picking the market for our examples. For every measured response to future uncertainty, there is a Taser being bid up to $120 before selling a single product or DrKoop.com IPOing at $50+.

    The fact of the matter is that markets can be very efficient and rational at times or they can be clusterfucks of panic and speculation. Mr. Professor’s point, that when people put up money for something they are therefore behaving rationally, is bullplop. People convince themselves of all manner of ridiculous things on a daily basis in the market.

  2. EW says:

    The Supreme Court has held that markets are efficient for purpose of prosecuting insider trading as a criminal matter. I once asked my dad if that was true, and he said, “yes..kind of….”

    How does market efficiency change when the quantum and speed of information changes? Information is spread more rapidly now than it was 50 years ago, exponentially faster than 200 years ago.

    I hate to beat on the rating agencies. But I read the Roger Lowenstein article on it a few months back. I am certainly no expert on finance and evaluating markets and individual investments.

    But I’d think behavioral finance types would really look at the credit raters. From reading that article, I gathered that banks typically reverse-engineer the ratings, to max the min and get the highest rating with minimal effort. I also assumed that the rating agencies can’t continuously shift its rating matrix to compensate.

  3. Mike says:

    EW – Hey! That article was like kicking the dog in addition to taking the box of ball point pens. In general, reverse-engineering the criterion isn’t bad, as the criterion is usually a good first approximate for a safe bond (high collateral, swifter payment schedule, etc.) All these new bond instruments, where instead of GM it is 10,000 poor homeowners scattered in the wind, it is much harder to see what to evaluate.

    Efficiency is a loaded term, and means a lot of different things to different people. Information technology has certainly seemed to made markets more efficient in terms of making a lot of previous (what people assumed were) inefficiencies disappear – December effects, small stock premiums, etc.

    And for purposes of getting rid of ‘arbitrage’, or making money easily with zero risk (the efficiency criterion for financial engineering), computers and information processing at quantum speeds are essential.

    It’s really bizarre to see images of trading equipment from the early 1900s, before all the math and computers; it’s like steampunk. Maybe I’ll post some pictures of it from online.

  4. EW says:

    My maternal grandfather was an arbitrageur for GMAC. He never completed college and probably never used a computer.

    I imagine his workplace in the 50s and 60s to be similar to the set of Mad Men. A bye-gone era, never to return.

  5. Pingback: Ad Men « Rortybomb

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