## Game theory in the stock market: On the Island of the Green-Eyed Tribe, blue eyes are taboo

In response to
yesterday’s piece a friend pointed out that John Maynard Keynes’ “stock market as a beauty contest” parable is an example of common knowledge game in modern game theory. Game theory is essentially a study of strategic decision making.
Hearing his comment I almost fell from my chair. “
Ab game theory bhi padhna padega?” I wondered. But as good friends usually do, my friend mailed across some excellent reference material. (You can read the two pieces by Ben Hunt who writes the Epsilon Theory newsletter here and here).
In this piece I have summarized the two pieces written by Ben Hunt and tried to explain how the stock market is currently working from a game theory point of view and what are the learnings that we can draw from it.
First we need to understand what a common knowledge game is. In order to understand that we will go through the example of the island of the green eyed tribe. On this island people have eyes that are green in colour. Anyone having blue eyes, is supposed to leave the island in a canoe at dawn, the morning after he has found out.
However there are two problems. There are no mirrors on the island. So no one knows what is the colour of their eyes. Further, residents are not allowed to tell each other what is the colour of their eyes. So, if Ajay knows that the colour of Vijay’s eye is blue, he is not allowed to tell Vijay about it.
To summarise, the island of the green eyed tribe is a small island. Given this, every resident knows the eye colour of everyone else who lives on the island, but himself.
In a normal scenario, if the island has residents with blue eyes, they could continue to live on the island. This happens because they themselves do not know they have blue eyes and no one else can tell them about it.
Now let’s say a missionary lands up on the island and declares that at least one resident of the island has blue eyes. Further, let’s say only one resident on the island has blue eyes. So what will happen in this case? This individual, let’s call him Ajay, knows that everyone else has green eyes, so he comes to the conclusion that he must be the one with blue eyes. Hence, next morning he gets into a canoe and leaves the island.
Simple!
Now let’s complicate the situation a little more. Let’s say two residents, Ajay and Vijay, have blue eyes. What do you think will happen here? Ajay and Vijay have seen each other and each thinks that the other has blue eyes. They themselves do not know that they have blue eyes. Hence, Ajay thinks that Vijay will leave the island on a canoe the next morning and vice versa.
Next morning, neither Ajay nor Vijay has left the island. This leaves both Ajay and Vijay confused. But they soon figure out the situation. Ajay thinks that Vijay hasn’t left the island because he has seen someone else with blue eyes. At the same time Ajay knows that everyone else other than Vijay has green eyes. Hence, that leaves only him with blue eyes.
Vijay also realises the same thing. The next morning both Ajay and Vijay leave the island. As Ben Hunt writes in an excellent newsletter titled
A Game of Sentiment and dated November 3, 2013, “The generalized answer to the question of “what happens?” is that for any n tribe members with blue eyes, they all leave simultaneously on the nth morning after the Missionary’s statement.”
But that is something for economists who carry out game theory experiments to ponder on. What is the learning here for stock market investors? Before the missionary lands up on the island every resident of the island knows the colour of the eyes of every other resident on the island. But this is private information which is locked up in the minds of the residents.
The missionary comes and changes this situation. He does not turn the information locked up in the minds of residents into public information, meaning he doesn’t tell them loud and clear that Ajay and Vijay are the ones with blue eyes.
Nevertheless, he turns what is private information until then into common knowledge. And common knowledge is different from public information.
As Hunt writes in a newsletter titled
When Does the Story Break and dated May 25, 2014, “Common knowledge is simply information, public or private, that everyone believes is shared by everyone else. It’s the crowd of tribesmen looking around and seeing that the entire crowd heard the Missionary that unlocks the private information in their heads and turns it into common knowledge. This is the power of the crowd watching the crowd, and for my money it’s the most potent behavioral force in human society.”
Further, it takes time for the residents of the island to realize what they know. It doesn’t happen immediately. As Hunt writes “The truth is that an enormous amount of
mental calculations and changes are taking place within each and every tribesman’s head as soon as the common knowledge is created. The more tribesmen with blue eyes, the longer the game simmers. And the longer the game simmers the more everyone – blue-eyed or not – questions whether or not he has blue eyes.”
In the example of Ajay and Vijay, it took them a day to realize that both of them have blue eyes. And once they did, they left the island the next morning, i.e two days after the missionary made the statement.
If there had been three people with blue eyes, it would have taken them three days and so on. That is how the dynamic works. So Ajay is watching Vijay and thinking that Vijay has blue eyes and hence, needs to leave the island. A similar dynamic is playing up in Vijay’s mind as well about Ajay.
The next day Vijay hasn’t left the island and Ajay realizes that Vijay is thinking the same thing about him, as he is thinking about Vijay. And once they have figured out they leave the island. So, nothing happens for two days and then they leave the island. In case of three people with blue eyes, nothing happens for three days and then they leave the island.
The point being it takes time for common knowledge to seep through and then there is immediate action.
If all that has left you wondering what all this has got to do with the stock market, allow me to explain. “If you haven’t observed exactly this sort of dynamic taking place in markets over the past five years, with nothing, nothing, nothing despite what seems like lots of relevant news, and then – boom! – a big move up or down as if out of nowhere – I just don’t know what to say. And I don’t know a single market participant, no matter how successful, who’s not bone-tired from all the mental anguish involved with trying to navigate these unfamiliar waters,” writes Hunt.
In the Indian context, the Sensex was yo-yoying over the last few years but has made a definitive move in 2014, with gains of nearly 33%. “And then boom,” is the best way to describe this move. That’s the power of the “crowd watching the crowd” for a while and then suddenly deciding to invest because the “common knowledge” of they thinking that everyone else is investing, seeps through.
That’s one part. The other part here is that of the “missionary” and the message he is sending out. The message will be believed depending on how credible the missionary is viewed to be and how loud is his voice. In the media this loudness and credibility is established by being seen at the right place. And that’s how the message is amplified.
As Hunt writes in
A Game of SentimentHow do we “see” a crowd in financial markets? Through the financial media outlets that are ubiquitous throughout every professional investment operation in the world – the Wall Street Journal, the Financial Times, CNBC, and Bloomberg. That’s it. These are the only four signal transmission and mediation channels that matter from a financial market CK (common knowledge) game perspective because “everyone knows” that we all subscribe to these four channels. If a signal appears prominently in any one of these media outlets (and if it appears prominently in one, it becomes “news” and will appear in all), then every professional investor in the world automatically assumes that every other professional investor in the world heard the signal.”
And this has an impact on the financial markets. In an Indian context one could add
The Economic Times to the list as well. Fund managers want to be featured in these publications because it increases their ability to influence the financial markets. The stories they want to tell people about explaining the various reasons behind what is an “easy money” driven bull market are more likely to be believed.
The big missionaries in the current scenario are the central banks. What they say is closely watched.
As Gary Dorsch, Editor, Global Money Trends newsletter, wrote in a recent column “Bad economic news is treated as bullish news for the stock market, because it lead to expectation of more “quantitative easing.” And the easy money flows that are injected by central banks go right past goods and services (ie; the real economy) and are whisked into the financial markets, where it pushes up the prices of stocks and bonds. In simple terms, what matters most to the stock markets are the easy money injections from the central banks, and to a lesser extent, the profits of the companies whose stocks they are buying and selling.”
But that is something that fund managers are not very comfortable talking about.

This piece originally appeared on www.equitymaster.com on Nov 26, 2014

## Central bankers are morons: Why bad economic news is treated as good news by stock market

Vivek Kaul

When it comes to investing in the stock market, there used to be two kinds of investors: those who invested on the basis of the fundamentals of a stock and and those who invested on the basis of non fundamentals.
Investors like Warren Buffett specialise in investing on the basis of fundamentals. These investors go through balance sheets, annual reports etc., in great detail, trying to figure out how well a company they want to invest in is doing in terms of sales, expenditure and profits.
On the other hand, the non fundamental investor most of the times is trying to do what John Maynard Keynes described best. John Lanchester writes about this “famous description” in his recent book
How to Speak Money” “He (i.e. the non fundamental investor) is looking at a photo of six girls and trying to pick, not which girl he thinks is the prettiest, and not which he thinks most people will think is the prettiest, but which most people will think most people will think is the prettiest…In other words the non-fundamentals investor isn’t trying to work out what companies he should invest in, or what company most investors will think they should invest in, but which company most investors will think most investors will want to invest in.”
Or as Keynes put it in his magnum opus
The General Theory of Employment, Interest and Money “It is not a case of choosing those [faces] that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
And this is how the stock market investors were neatly divided with the majority of them trying to figure out “ what average opinion expected the average opinion to be”. This neat division was broken down in the aftermath of the current financial crisis which started in September 2008. The markets are now ruled by the central banks.
As Ben Hunt wrote in the Epsilon Theory investment letter dated August 5, 2014, and titled
Fear and Loathing on the Marketing Trail, 2014 “Today, everyone believes that market price levels are largely driven by monetary policy and that we are all being played by politicians and central bankers using their words for effect rather than direct communication.”
Monetary policy is essentially the process by which a central bank controls the amount of money in the financial system of a country. In the aftermath of the financial crisis, central banks of Western economies started printing money.
Economist John Mauldin in a recent column titled
The End of Monetary Policy estimates that central banks have printed \$7-8 trillion since the start of the financial crisis. It is worth pointing out here that this money is not actually printed, but created digitally, nonetheless “money being printed” is an easier way to talk about the whole thing.
Once this new money is created it is used to buy bonds, both private as well as government. This has been done to pump money into the financial system and ensure that there is enough money going around to keep interest rates low.
At low interest rates the hope was that people would borrow and spend more. This would create some demand and help economic growth. But that did not happen. What happened instead was that this newly created money found its way into financial markets all over the world.
This broke down the link between economic performance of a country and the performance of its stock market. The stock markets rallied anyway. This point was very well made recently by
Claudio Borio, the head of the Bank of International Settlement’s monetary and economic department: “Buoyant financial markets are out of sync with the shaky global economic and geopolitical outlook. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally. Financial markets are euphoric, in the grip of an aggressive search for yield, and yet investment in the real economy remains weak while the macro-economic and geopolitical outlook is still highly uncertain.”
This has led to a situation where bad economic news is treated as good news by the stock markets because the investors know that this will lead to central banks printing more money as they try and get economic growth going again.
As Gary Dorsch, Editor, Global Money Trends newsletter, wrote in a recent columnBad economic news is treated as Bullish news for the stock market, because it lead to expectation of more “quantitative easing.” And the easy money flows that are injected by central banks go right past goods and services (ie; the real economy) and are whisked into the financial markets, where it pushes up the prices of stocks and bonds. In simple terms, what matters most to the stock markets are the easy money injections from the central banks, and to a lesser extent, the profits of the companies whose stocks they are buying and selling.”
This single paragraph explains all the stock market rallies that have happened all over the world in the last few years. At the same time the “easy money” created by central banks has also helped boost corporate profits. As Dorsch puts it “The boom in corporate profits has been heavily subsidized by cheap and easy credit, which has allowed big companies to boost returns by paring down interest costs and buying back shares.” And this has also boosted stock market performance. The question is till when can this last? Do investors really believe that central banks will keep coming to their rescue forever? These are not easy questions to answer and on this your guess is as good as mine.
Hunt who writes the Epsilon Theory newsletter believes that “No one requires convincing that market price levels are unsupported by real world economic activity. Everyone believes that this will all end badly, and the only real question is when.”
Albert Edwards of Societe Generale is a little more direct about the issue. As he wrote in recent research note dated October 23, 2014: “The central banks for all their huffing and puffing cannot eliminate the business cycle. And they should have realised after the 2008 Great Recession that the longer they suppress volatility, both economic and market, the greater the subsequent crash. Will these morons ever learn?” He also quotes Guy Debelle, head of the BIS market committee, as saying that “investors had become far too complacent, wrongly believing that central banks can protect them, and many staking bets that are bound to “blow up” at the first sign of stress.”
The Federal Reserve of the United States has gradually been winding down its money printing programme. Currently it prints \$15 billion every month. The Federal Open Market Committee is supposed to meet on October 28-29, later this month. The expectation is that the committee will wind up the money printing programme.
The stock market in the US has remained largely flat over the last two months. In case it starts to fall, once the Federal Reserve stops printing money, it is likely that the American central bank will start printing money again. As Christopher Wood wrote in the
Greed and Fear investment newsletter in November last year “The key issue is what might trigger a market correction. The market consensus continues to focus on the tightening in financial conditions triggered by “tapering”. Still such a hypothetical correction is not so big a deal to GREED & fear, since any real equity decline caused by tapering is likely to lead, under a Fed run by Janet Yellen, to renewed easing.”
So what is the real threat then? “The real threat to US equities is when the American economy fails to re-accelerate as forecast,” wrote Wood. And that is something worth worrying about.

The article originally appeared on www.FirstBiz.com on Oct 26, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

## Money printing is ineffective: Why monetary policy, as we know it, is nearing its death

Vivek Kaul

Everything under the sun is in chaos. The situation is excellent.
– Mao Zedong

It has been a little over six years since the start of the current financial crisis in mid September 2008, when the investment bank Lehman Brothers went bankrupt. In the aftermath of the financial crisis the Western central banks went on a money printing binge.
Economist John Mauldin in a recent column titled
The End of Monetary Policy estimates that central banks have printed \$7-8 trillion since the start of the financial crisis. It is worth pointing out here that this money is not actually printed, but created digitally.
As John Lanchester writes in his wonderful new book
How to Speak Money “It’s money that simply didn’t exist before. It’s like typing 100,000 at a keyboard and magically having £ 100,000 added to your bank account.”
Hence, this money is not actual printed money. As Tim Harford writes in
The Undercover Economist Strikes Back: “A lot of it is money…not actual printed ‘paper money’ but ‘printing money’ is the simple way to talk about this.”
Once this new money has been created it is used to buy bonds, both private as well as government. This has been done to pump money into the financial system and ensure that there is enough money going around to keep interest rates low.
At low interest rates the hope was that people would borrow and spend more. This would create some demand and help economic growth. But has that really happened? The major creator of new money in the last six years has been the Federal Reserve of United States, the American central bank. It has printed (oops digitally created) around \$3.6 trillion of new money since the financial crisis started. And it still continues to do so.
The hope as Henry Hazlitt put it in his book
Economics in One Lesson is that “this increased money [will increase]…everyone’s “purchasing power,” in the sense of everybody to buy more goods than before.”
Nevertheless this hasn’t led to a jump in consumer expenditure. Household consumption forms nearly 70% of the American economy.
As economist Stephen Roach wrote in a recent column “In fact, since early 2008, annualized growth in real consumer expenditure has averaged a mere 1.3% – the most anaemic period of consumption growth on record.”
This is reflected in the growth of the American GDP as well. As Roach points out “Though \$3.6 trillion of incremental liquidity has been added to the Fed’s balance sheet since late 2008, nominal GDP was up by just \$2.5 trillion from the third quarter of 2008 to the second quarter of this year.”
Hence, what economists call the “multiplier effect” hasn’t really worked.
The other hope was that all this new money would chase the same amount of goods and services, and this, in turn, would lead to some inflation. As prices would start to rise people would buy goods and services in the hope of getting a better deal.
But that hasn’t happened either. As John Mauldin writes “France has inflation of 0.5%; Italy’s is -0.2% (as in deflation); the euro area on the whole has 0.4% inflation; the United Kingdom (which still includes Scotland) is at an amazingly low 1.5% for the latest month, down from 4.5% in 2011; China with its huge debt bubble has 2.2% inflation.” The inflation in the United States is at 1.7%. This is below the Federal Reserve’s stated goal of 2%.
The only developed country which has managed to create some inflation is Japan. The inflation in Japan is at 3.4%. So has the money printing by Japan managed to create some inflation? Not really. As Mauldin explains “What you find is that inflation magically appeared in March of this year when a 3% hike in the consumption tax was introduced. When government decrees that prices will go up 3%, then voilà, like magic, you get 3% inflation. Take out the 3% tax, and inflation is running about 1%.”
Instead of reviving consumer expenditure and creating inflation, all the printed money has been borrowed by institutional investors at very low rates of interest and been invested in financial markets all over the world. Stock markets in various parts of the world have seen huge rallies despite economic growth stagnating. Central banks have hoped that these rallies might lead to a wealth effect. Wealth effect is a situation where the rising value of the financial assets makes people feel richer and hence, spend more money.
But that doesn’t seemed to have worked either. As Roach writes “The operative view in central-banking circles has been that the so-called “wealth effect” – when asset appreciation spurs real economic activity – would square the circle for a lagging post-crisis recovery. The persistently anaemic recovery…belie this assumption.”
This anaemic recovery is visible in the low economic growth rates prevalent through large parts of the developed world. As Mauldin writes “The European Union grew at 0.1% last year and is barely on target to beat that this year. The euro area is flat to down. The United Kingdom and the United States are at 1.7% and 2.2% respectively. Japan is in recession. France is literally at 0% for the year and is likely to enter recession by the end of the year. Italy remains mired in recession. Powerhouse Germany was in recession during the second quarter.”
What all this clearly tells us is that what central banks call “monetary policy” is not working as it is expected to.
Investopedia defines monetary policy as “The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rate.”
The irony of course is that even though the monetary policy is not working the central banks around the world don’t seem to be in a hurry to get rid of it. The money printing programme in the United States has more or less come to an end. Nevertheless, the Federal Reserve has made it clear that it is no hurry to withdraw all the money that it has printed and pumped into the financial system. Hence, it hopes to keep long term interest rates low for sometime.
Other parts of the developed world though are still going strong on money printing. As Ben Hunt,
Chief Risk Officer, Salient Partners, wrote in a recent newsletter titled Going Gray “The biggest thing happening in the world today is the growing divergence between US monetary policy and everyone else’s monetary policy. There is a schism in the High Church of Bernanke, with His US acolytes ending the quantitative easing [the technical term the economists have given to printing money] experiment in no uncertain terms, and His European and Japanese prelates looking to keep the faith by continued balance sheet expansion.”
Despite its non-effectiveness, central banks still have faith in monetary policy, as it has been practised over the years. And this might lead to monetary policy totally collapsing in the years to come.
To conclude, let me quote Mauldin: “Sometime this decade (which at my age seems to be passing mind-numbingly quickly) we are going to face
a situation where monetary policy no longer works. Optimistically speaking, interest rates may be in the 2% range by the end of 2016, assuming the Fed starts to raise rates the middle of next year and raises by 25 basis points per meeting. If we were to enter a recession with rates already low, what would dropping rates to the zero bound again really do? What kind of confidence would that tactic actually inspire? And gods forbid we find ourselves in a recession or a period of slow growth prior to that time. Will the Fed under Janet Yellen raise interest rates if growth sputters at less than 2%?”
These are questions worth thinking about.

The article originally appeared on www.FirstBiz.com on Oct 13, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

## Fed may be reducing easy money, but here’s why Sensex will keep soaring

Vivek Kaul

In theory there is no difference between theory and practice. In practice there is.

Yogi Berra

A question I am often asked is why are the stock markets around the world still rallying despite the Federal Reserve of United States going slow on printing money. In a statement released yesterday the Fed decided to cut down further on money printing.
It will now print \$15 billion per month instead of the earlier \$25 billion. This was the seventh consecutive cut of \$10 billion. Since December 2012, the Federal Reserve had been printing \$85 billion per month. This money was pumped into the financial system by buying mortgage backed securities and government bonds. The idea was that by increasing the amount of money in the financial system, long term interest rates could be driven lower. The hope was that at lower interest rates, people would borrow and spend more.
From January 2014, the Federal Reserve decided to buy bonds worth \$75 billion a month, instead of the earlier \$85 billion. This meant that the Fed would be printing \$75 billion a month instead of the earlier \$85 billion. This cut in money printing came to be referred to as “tapering”, which means getting progressively smaller. Since then the amount of money being printed by the Federal Reserve has been tapered to \$15 billion per month. At this pace the Federal Reserve should be done at dusted with its money printing by next month i.e. October 2014.
A lot of this printed money instead of being lent out to consumers has found its way around into stock markets and other financial markets around the world. The Dow Jones Industrial Average, America’s premier stock market index, has rallied more than 30% since October, 2012. This when the American economy hasn’t been in the best of shape.
The FTSE 100, the premier stock market index in the United Kindgom, has given a return of 15% during the same period. The Nikkei 225, the premier stock market index of Japan has rallied by 53% during the same period. Closer to home, the BSE Sensex has rallied by around 43% during the same period.
Stock markets around the world have given fabulous returns, despite the global economy being down in the dumps. The era of easy money unleashed by the Federal Reserve has obviously helped.
Nevertheless, the question is with the Fed clearly signalling that the easy money era is now coming to an end, why are stock markets still holding strong? One reason is the fact that even though the Fed might be winding down its money market operations, other central banks are still continuing with it.
The Bank of Japan, the Japanese central bank is printing around ¥5-trillion per month and is expected to do so till March 2015. The European Central Bank is also preparing to print €500-billion to €1-trillion over the next few years. What this means is that interest rates in large parts of the Western world will continue to remain low. Hence, big institutional investors can borrow from these financial markets and invest the money in stock markets around the world.
The second and more important reason is that the Federal Reserve does not plan to shrink its balance sheet any time soon. Before the financial crisis started in September 2008, the size of the Federal Reserve balance sheet stood at \$925.7 billion. Since then it has ballooned and as on August 27, 2014, it stood at \$4.42 trillion.
The size of the Fed balance sheet has exploded by close to 378% over the last six years. This has happened primarily because the Fed has printed money and pumped it into the financial system by buying bonds, in the hope of keeping interest rates low and getting people to borrow and spend.
Janet Yellen, the current Chairperson of the Federal Reserve made it very clear yesterday that the Fed was in no hurry to withdraw this money from the financial system. It could take to the “end of the decade” to shrink the Fed’s huge balance sheet
“to the lowest levels consistent with the efficient and effective implementation of policy.”
What this essentially means is that the money that the Fed has printed and pumped into the financial system by buying bonds, will not be suddenly withdrawn from the financial system. When a bond matures, the institution which has issued the bond, repays the money invested to the institution that has invested in it.
If the investor happens to be the Federal Reserve, the maturing proceeds are paid to it. This leads to the amount of money in the financial system going down, and could lead to interest rates going up, as money becomes dearer.
This is something that the Fed does not want, in order to ensure that individuals continue borrow and spend money, and this, in turn, leads to economic growth. Hence, the Fed will use the money that comes back to on maturity, to buy more bonds and in that way ensure that total amount of money floating in the financial system does not go down.
This means that long term interest rates will continue to remain low. Hence, investors can continue to borrow money at low interest rates and invest that money in different parts of the world.
Yellen also clarified that short-term interest rates are also not going to go up any time soon. As she said “economic conditions may for some time warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.”
The federal funds rate is the interest rate that banks charge each other to borrow funds overnight, in order to maintain their reserve requirement at the Federal Reserve. This interest rate acts as a benchmark for short-term loans.
Given these reasons, the stock markets around the world will continue to rally, at least in the near term, as the era of easy money will continue. These rallies will happen, despite global growth being down in the dumps and the fact that the global economy is still to recover from the financial crisis that started just about six years and three days back, when the investment bank Lehman Brothers went bust on September 15, 2008.
To conclude, Ben Hunt who writes the Epsilon Theory newsletter put it best in a recent newsletter dated September 8, 2014, and titled
The Ministry of Markets: “No one doubts the omnipotence of central banks. No one doubts that market outcomes are fully determined by central bank policy. No one doubts that central banks are large and in charge. No one doubts that central banks can and will inflate financial asset prices. And everyone hates it.”
The article appeared originally on www.FirstBiz.com on Sep 18, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

## Everybody loves a good story

Vivek Kaul

I am writing this piece sometime in the middle of April 2014. The stock market in India has been on fire over the last one month, with the NSE Nifty and the BSE Sensex regularly touching new highs. Every time the market touches a new high, editors of newspapers/magazines/websites have to look for a new reason to explain the bull run.
Several reasons have been offered during the course of the last one month. First we were told that the stock market investors were betting on Narendra Modi becoming the Prime Minister. The numbers in this case didn’t really add up. The domestic institutional investors sold stocks worth Rs 13,130.77 crore during March 2014. Their selling continued in April as well. Till April 11, 2014, the domestic institutional investors had sold stocks worth Rs 3,728.06 crore. If these investors are really supporting Modi, then why are they selling out of the stock market?
Then we were told that the foreign investors were betting on Modi coming to power and setting the faltering Indian economy right. In this case, the numbers do add up. In March 2014, foreign institutional investors bought stocks worth Rs 25,376.45 crore. In April, the trend continued and by April 11, they had bought stocks worth Rs 3,658.21 crore.
But is the logic as simple as that? It is worth remembering here that the Western central banks have been running an “easy money” policy for a while now. The Federal Reserve of the United States, has been reducing the amount of money it has been printing since the beginning of the year. But at the same time it has reiterated time and again that short term interest rates will continue to be close to 0% in the near future.
Interestingly, the Fed repeated this in a statement released on March 19, 2014. The foreign institutional investors invested Rs 4,222.10 crore on March 21, 2014, in the Indian stock market. This is the highest amount they have invested on any single day, since the beginning of this year. So, are the foreign investors investing in India because they have faith in Modi? Or are they simply investing because “easy money” continues to be available to them at rock bottom interest rates? The stories appearing in the media haven’t got around to explaining that.
Another theory that went around briefly was that the stock market is rallying because India’s economic data had been improving. Inflation was down. Industrial output as measured by the index of industrial production had marginally improved. And the current account deficit had been brought under control. This theory lasted till the index of industrial production for the month of February 2014 was declared. Industrial output for the month was down 1.9%.
The conspiracy theorists also suggested that it was the black money of politicians coming back to India. They needed that money to fight elections. Well, if they needed that money, they would have sold their stock market holdings, and the stock market would have fallen. But that hasn’t really happened.
So what is happening here? As Ben Hunt writes in a newsletter titled Epsilon Theory and dated February 28, 2014 “Ants, bees, termites, and humans – the most successful species on the planet – are constantly signaling each other so that we can make sense of our world together. That’s the secret of our success as social animals.”
The point is that everybody loves a good story. We want coherent explanations of what is happening in the world around us. As Nassim Nicholas Taleb writes in The Black Swan—The Impact of the Highly Improbable “We love the tangible, the confirmation, the palpable, the real, the visible, the concrete, the known, the seen, the vivid, the visual, the social, the embedded, the emotionally laden, the salient, the stereotypical, the moving, the theatrical, the romanced, the cosmetic, the official…the lurid. Most of all we favour the narrated.
And this is where the media comes in, which tries to give us convincing explanations of what is happening in the world around us. Whether the reason behind a market movement is the real reason or not, does not really matter, as long as it sounds sensible enough. Taleb gives an excellent example of the same in The Black Swan.
“One day in December 2003, when Saddam Hussein was captured, Bloomberg News flashed the following headline at 13:01: U.S. TREASURIES RISE, HUSSEIN CAPTURE MAY NOT CURB TERRORISM,” Taleb writes.
Basically, what Bloomberg was saying was that the capture of Hussein will not curb terrorism and hence, investors had been selling out of other investments and buying the safe US government bonds, thus pushing up the price.
Around half an hour later, Bloomberg had a different headline. As Taleb writes “At 13:31 they issued the next bulletin: U.S.TREASURIES FALL: HUSSEIN CAPTURE BOOSTS ALLURE OF RISKY ASSETS.”
What had happened was that during a period of half an hour the price of the US government bonds had fluctuated. First they had risen as investors had bought the bonds. In half an hour’s time some selling had happened and the prices were falling. Bloomberg now told its readers that prices were falling because investors were selling out of US government bonds and looking at other investments given that with the capture of Hussein, the world was a much safer place.
Hunt offers a similar example in his newsletter. On November 28, 2008, Barack Obama, who had just been elected the President of the United States, appointed Tim Geithner, the President of the Federal Reserve Bank of New York, as his Treasury Secretary. The S&P 500, one of America’s premier stock market indices, rallied by about 6% on that day and Geithner’s nomination was deemed to be the major reason behind the same. As Hunt writes “All of the talking heads on the Sunday talk shows that weekend referenced the amazing impact that Geithner had on US markets, and this “fact” was prominently discussed in his confirmation hearings. Clearly this was a man beloved by Wall Street, whose mere presence at the economic policy helm would soothe and support global markets. Yeah, right.”
Geithner’s nomination was good news, but was it big enough to drive up the stock market up by 6% in a single day? As Hunt explains “So long as Obama didn’t nominate a raving Marxist I think it would have been a (small) positive development in the context of the collapsing world of November 2008. Was the specific nomination of specifically Tim Geithner WHY markets were up so much on November 24th? Of course not.”
The moral of the story is that first things happen and then people go looking for reasons. Hunt calls it “the power of why”. As he writes “It is the Power of Why, and it has no inherent connection to any true causal connection or the way the world truly works. Maybe it’s all true. Probably it’s partially true. But it really doesn’t matter one way or another.”
What is true of the financial markets in particular is also true for the world at large in general. As Taleb puts it “It happens all the time: a cause is proposed to make your swallow the news and make matters more concrete. After a candidate’s defeat in an election, you will be supplied with the “cause” of the voters’ disgruntlement. Any conceivable cause can do. The media, however, go to great lengths to make the process “thorough” with their armies of fact-checkers. It is as if they wanted to be wrong with infinite precision.”
So what is the way out? Taleb has an excellent suggestion in his book Fooled By Randomness—The Hidden Role of Chance in Life and in the Markets “To be competent, a journalist should view matters like a historian, and play down the value of the information he is providing, such as by saying “Today the market went up, but this information is not too relevant as it emanates mostly from noise.””
But that is easier said than done.

The article originally appeared in the May 2014 issue of the Wealth Insight magazine

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected]