|By Euan Wilson
Originally published in the Sept. 2010 Socionomist
“Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally FALLS. When the price of a financial asset rises, demand generally INCREASES.”
—The Economist, August 12, 2010
As mainstream commentators ponder the spectacular failures of the Efficient Market Hypothesis and Asset Pricing Theory, some are beginning to recognize the value of the socionomic perspective.
In an August issue of The Economist, the magazine’s Buttonwood column related how the price/demand relationship differs radically in the contexts of finance versus economics. “Financial markets do not operate in the same way as those for other goods and services,” the unnamed author observes.
The column discusses classical Demand and uses computer software as its example. As computer software gets more expensive, fewer people buy it, the author notes, and as it becomes cheaper, more people buy it. But when the price of a stock goes up, the quantity demanded goes up with it, and the opposite occurs on the way down. This is the converse of the software example and not at all what is taught in college economics classes.
The Buttonwood column, named for the tree under which 24 brokers signed the agreement to form the New York Stock Exchange, concludes, “Surely there are rational investors who can profit from market booms and panics? There are some, but not enough. Such rational beings are simply overwhelmed by the force of the herd.”
Three years ago, Robert Prechter and Wayne Parker introduced the socionomic theory of a “Financial/Economic Dichotomy” in the well-known Journal of Behavioral Finance.1 Their paper stated that financial markets and the markets for goods and services are impelled by different motivating factors, and they used computer sales as their economic example.
We are delighted to see important socionomic ideas gain exposure in a mainstream publication such as The Economist. However, socionomic theory proposes a different view of precisely why crashes occur. The article reads:
The feedback mechanism … seems pretty clear. A period of rising markets and steady economic growth creates the incentive for investors to speculate with borrowed money. This speculation drives prices even higher, until some shock … causes the boom to implode.
Socionomics points out that the “feedback-until-shock” concept fails to account for why economic growth or shocks would occur in the first place; assumes that the loop cannot collapse under its own weight; in the absence of a satisfactory exogenous shock, requires that a boom go on forever; and does not account for the genesis of a mania at one time versus another or in a particular market versus another.
The Socionomic Theory of Finance (STF) and its associated Elliott wave model of financial price behavior resolve all of these issues: They explain that waves of economic growth and contraction derive from waves of social mood; they describe how markets trend and turn naturally, without exogenous catalysts; they reveal why “exogenous shocks” have no predictive value; and they describe developments that presage manias and crashes. Financial market trends and reversals are unconscious expressions of herding, not the result of rational cogitation. In The Wave Principle of Human Social Behavior (1999), Prechter explained the effect herding has on even a rational investor’s aversion to selling: “Even the person who thinks he should take action experiences a strong psychological pressure to refrain from doing so.” And in the “Financial/Economic Dichotomy,” Prechter and Parker accounted for the revisionist tendencies of post-crash analysis. They said, “respondent-stated reasons for the huge stock market decline appear to be belated rationalization for actions born of panic.” But perhaps most crucially, they explained what causes the moves from rise to fall and back again: “The ceaseless dynamism of waves, fluctuating between optimism and pessimism” causes trends, peaks and nadirs in the markets. “Because price trends continually stop and reverse, there can be no continuously reinforcing feedback loop.”
Prechter and Parker’s paper went far further in challenging economics-based financial models, which assume that markets are rational and operate through the forces of supply and demand. Economics-based models fail to recognize bubbles when they are under way, much less can they predict them. The Elliott wave model, in contrast, has manias and crashes built into its fractal form. Economics-based models also justify institutionalized easy credit and other maniacal behaviors such as the adoption of financial derivatives. In short, classical models exacerbate manias rather than predict and protect against them.
In this limited space we cannot express the full utility of the “Financial/Economic Dichotomy” paper. Last year, the Socionomics Institute made it freely available. In light of The Economist article, we’d like to offer it again. Click here to read it now.
1Prechter, R. & Parker, W. (2007). The financial/economic dichotomy in social behavioral dynamics: the socionomic perspective. The Journal of Behavioral Finance, 8(2). 84-108.
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Most economists, historians and sociologists
presume that events determine society’s mood. But socionomics hypothesizes
the opposite: that social mood regulates the character of social events. The
events of history—such as investment booms and busts, political events,
macroeconomic trends and even peace and war—are the products of a naturally
occurring pattern of social-mood fluctuation. Such events, therefore, are not
randomly distributed, as is commonly believed, but are in fact probabilistically
predictable. Socionomics also posits that the stock market is the best available
meter of a society’s aggregate mood, that news is irrelevant to social
mood, and that financial and economic decision-making are fundamentally different
in that financial decisions are motivated by the herding impulse while economic
choices are guided by supply and demand. For more information about socionomic
theory, see (1) the text, The
Wave Principle of Human Social Behavior © 1999, by Robert Prechter;
(2) the introductory documentary History's
Hidden Engine; (3) the video Toward
a New Science of Social Prediction, Prechter’s 2004 speech before
the London School of Economics in which he presents evidence to support his
socionomic hypothesis; and (4) the Socionomics Institute’s website, www.socionomics.net.
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