Market Narratives Have Pushed Aside Fundamentals
Logic and mathematics once made up the basic laws of investing. No more.
Bloomberg, June 17, 2021
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Filmmakers use the phrase “Narrative Is Everything” to emphasize the importance of storytelling to their craft. They understand how a good storyline communicates to the viewer, draws them in and makes them root for the protagonist. Without a good narrative, even the best casts inhabiting the most wonderful characters risk failing to entertain. Great narratives can terrify you, warm your heart, or compel your attention.
It seems that narratives have everything to do with markets these days, which is also creating new risks for investors. The biggest, most divisive debates are about stories rather than fundamentals, ranging from the utility of cryptocurrencies to whether the current spike in inflation is transitory, and from whether sky-high valuations are warranted to whether there is too much fiscal and monetary stimulus.
This is in stark contrast to how beliefs about investing have evolved — beliefs based on mathematics and cold, hard logic. The “narrative paradigm” can be traced to a communication theory conceptualized by the late Walter Fisher, professor emeritus at the USC Annenberg School for Communication and Journalism. Fisher observed that meaningful communication occurs via storytelling because “stories are more persuasive than logical arguments.”
Consider the following examples of narratives as the drivers of, well, just about anything in markets today:
Bitcoin: Fiat currency has been debased by government bailouts, central bank largesse and other ill-advised interventions! It is an eventuality that this recklessness leads to a massive shift to digital currency. Buy Bitcoin and drive Lamborghinis or stay with fiat currency and own worthless paper.
Worker Shortage: Generous unemployment benefits are keeping lazy, ungrateful scoundrels from going back to work! Counter-narrative: Many schools are still operating remotely and childcare is hard to find. Plus, a large number of new business formations and a record number of people quitting their jobs shows workers are not lazy, just avoiding inflexible, low-paying jobs.
Passive Indexing: It is hard to pick winning stocks! Not only that, it’s expensive to hire the people who might be able to pick winning stocks (and you don’t know who they are until too late). Why not instead just buy a cheap index of the biggest stocks, or the entire market?
Inflation: Combine ultra-low interest rates and big stimulus with pent-up demand as the vaccines lead more of the economy to open. This story is the perfect formula for rising prices and higher inflation expectations!
Valuation: Buying stocks below their intrinsic value is a good way to make money over the long-term. Counter-narrative: Traditional measures of value must be more robust than just price-to-sales or price-to-earnings ratios; it must include growth rate and intangibles such as patents, algorithms and business processes.
Meme stocks: The collective power of the internet can stick it to the man! r/Wall Street Bets can identify heavily shorted stocks, and as a group buy out of the money calls, forcing a massive short-squeeze. Power to the people!
The idea of meme stocks as a narrative led me to reach out to Yale University professor and Nobel laureate Robert Shiller to ask whether “everything is narrative” is an overstatement. He is also the author of “Narrative Economics: How Stories Go Viral and Drive Major Economic Events.” In an email exchange, he pointed out that narrative is but half of it:
“A story becomes newly on everyone’s lips not because it is true but because its contagion rate has gone up or recovery rate has gone down, just as viruses can see surprising new spread because of a subtle mutation. Contagion rates of stories are affected by such things as superficial resemblance to recent events, celebrity connections, and even sometimes by their outrageous daring falsehoods.”
Hence, the inherent power of storytelling is only part of the picture. Much of narrative’s influence comes from a plot line’s virality. A good story might persuade you, but a great one can go viral. Bitcoin becoming a trillion-dollar asset not only due to the strength of the story behind it – the genesis myth of Satoshi, technology applications of blockchain, the inherent scarcity of mined coins, and the post-financial crisis interventions by governments worldwide – but how that narrative resonates with so many differing factions of investors.
But these “narrative fallacies” present an obvious risk for investors. When we believe a compelling story that turns out to be not true, we can end up holding assets worth far less than the story suggested. This is especially true in the market’s daily price action, which can be “noisy and irrational.”
Shiller adds that stock prices are quite substantially driven by narratives, but over time they will revert to reality: “I have been saying that the efficient markets theory is [at least] half true.” Hence, viral narratives can be the initial drivers of higher valuations, but those companies must, eventually, deliver revenue growth and earnings.
To update what Benjamin Graham, the father of value investing, once said: “In the short run, the market is a narrative machine, but in the long run, it is a narrative debunking machine.”
UPDATE: July 2, 2021
Interesting research piece on Crypto that plays into the narrative issue: Distrust or Speculation? The Socioeconomic Drivers of U.S. Cryptocurrency Investments.
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I originally published this at Bloomberg, June 17, 2021. All of my Bloomberg columns can be found here and here.
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