10/20/99

Kathleen O'Toole, News Service (650) 725-1939; e-mail: kathleen.otoole@stanford.edu

Stock market volatility: Why investors' beliefs increase market uncertainty

At least once a week, someone asks Mordecai Kurz if the current stock market prices are too high or too low. The Joan Kenney Professor of Economics responds, "You are asking the wrong question."

The question should be, "Is the market too high or too low relative to my own view of what's underlying it?" Kurz told alumni who gathered at the Stanford Institute for Economic Policy Research on Thursday, Oct. 14, as part of Reunion Homecoming Weekend activities.

"If you believe technology today is allowing the market to grow, the markets are not high, but if you don't believe that, the market is extremely high," Kurz said.

In other words, investor optimism or pessimism about future productivity growth is a key part of market movements. The current bull market will change to a bear precisely when enough investors change their beliefs about the underlying fundamentals, not when the fundamentals themselves change, Kurz said. If you accept his view that people have imperfect understanding of information about how the world is changing, then you can use your own understanding of that phenomenon to win big ­ or lose big. Those whose beliefs are right, Kurz joked, "are the ones who contribute to our institute."

A longtime student of investor performance as well as other economic subjects, Kurz published his theory of "rational beliefs and endogenous uncertainty" in 1994. It contradicted textbook explanations of how financial markets work and became the subject of a special symposium issue of the journal Economic Theory and a book in 1997. In a Fortune magazine article, Nobel laureate and Stanford Professor Kenneth Arrow called Kurz's work "an important step forward in our understanding of markets." The theory has much to recommend it, Stanford economist Robert Hall commented at the alumni session, but it lacks enough econometric test results to replace the prevailing paradigm, known best as rational expectations theory,

The prevailing theory doesn't fare as well on such tests with real-world data as his theory, Kurz pointed out at the alumni session. Among the market facts that rational expectations models cannot explain are the suddenness and degree of volatility seen in stock prices, the size of the premium that stocks pay over less risky Treasury bills, and the volatility in currency exchange rates.

Under rational expectations, financial markets are said to be efficient and to set prices at their real value because buyers and sellers behave in their rational self-interest based on broadly shared information about the economy and individual companies in it. People can be caught off guard, however, when sudden shocks occur outside the economy ­ events like an earthquake or weather conditions that impact economic productivity.

In Kurz's rational beliefs theory, deep structural changes also occur over time within the economy, and investors can't know about them for sure until after the fact. As examples, he cited the strong U.S. growth regime from 1944 to 1966 followed by a downturn until 1981. "The current regime began in 1981 driven by technology. The highest returns went to those who recognized the change early in the 1980s," he said.

"The history of the process is reasonably regular and can describe how things operate normally," Kurz said, but the averages calculated from history are "not good predictors of the next 12 to 14 months." As a result, investors don't know how to compute a correct price and must make their own forecast, which he calls a rational belief, rather than a rational expectation.

"A rational belief is a theory about the market that cannot be contradicted by past data," but there can be many different rational beliefs. Therefore, not all rational investors can be right, he said. "This is a concept difficult for economists to accept. Under rational expectations, you are godlike and you never make a mistake. I suggest to you this is an unreasonable view of the world," Kurz said, prompting knowing laughter from his audience.

Individual investors' mistaken but rational beliefs are usually not random but correlated because investors "listen to each other and read the same newspapers and watch the same television programs," Kurz said. Therefore, news about a small change in a company's earnings or some other fundamental economic fact often causes a greater price change than the news would justify.

Beliefs tend to persist until people see a reason to change them, he said, and so there are times when a consensus among investors exits and times when the distribution of beliefs is very broad. In non-consensus conditions, diverse forecasts tend to balance each other. When the distribution of beliefs is narrow, he said, prices are more likely to take larger swings as people change their beliefs.

In his simulations, Kurz said he can replicate real-world market fluctuations better than rational expectation economists by assuming there are both optimistic and pessimistic investors at the same time. "On average, most people are optimistic, but when they become pessimistic, they become intensely pessimistic. Both the intensity and frequency" of investors' changing beliefs about the market will affect market prices. At any moment, he said, a small minority is very afraid of a recession and buys Treasury bills, an explanation for a higher risk premium on stocks than predicted by rational expectations theories. The same pessimism affects foreign exchange markets and results in more volatility than justified by the economics underlying national currency values, he said.

Members of the audience asked Kurz if the current explosion of Internet day traders would affect stock prices more than other investors and whether his theory, if correct, would make it possible for government to introduce regulations to reduce volatility. The latter question, he said, was "very interesting, but I have avoided it like the plague in my writing because I already am involved in enough controversies."

Theoretically, regulators could set a price range, he said, above or below which prices would not be allowed to fall. "But the problem is that the government is not smarter than anybody else."

Regarding day traders, Kurz said that given the role of beliefs, "who are we to judge who is irrational?"

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By Kathleen O'Toole