Narrative Economics by Robert Shiller - Storytelling but no predictions

Economics is a social science. It tries to explain the behavior of consumers and producers, and the interaction of buyers and sellers. It is not physics. Expectations are constantly being made based on changing sets of data and the reaction of different groups. There is herd mentality. At the extreme, there is the madness of crowds. There is rationality in beliefs, but also individual and group biases. It is a complex web or network of action and reaction.

Quantitative models try to simplify the complex through testable hypotheses based on models assuming rationality, but behavior may not follow the simplifying assumptions often employed. Consequently, the history and structure of markets adds important color and explanation for behavior.

The new book, Narrative Economics by Robert Shiller, tries to put the social back into the science of economics through a discussion of how the mood, feelings, and meme of narratives rise and fall through time. Narratives have a contagious flow like a disease. Narratives may start out slow, then build and finally exhaust and fall. With narrative comes changes in sentiment and behavior.

I appreciate the importance of narrative and how it may create fads and fashion which influence demand, but the challenge of economics as a science is to generate testable hypotheses provide predictions. This is the core view of the Friedman positive economics, Chicago School, approach. By a standard of attempting to provide meaningful predictions of phenomena not yet observed, the book fails.

The ebb and flow of narrative is interesting, but Shiller does not provide any testable hypotheses on why these narrative themes will begin or end. He discusses the Kermack-McKendrick model of disease epidemics which is an interesting approach for thinking about narrative growth, but this does not help us with why some ideas stick. Shiller uses the frequency of words as measured by Google Ngrams to show the trends of narrative, but this is only descriptive not predictive. 

Narratives come and go, but this work provides no link between stories and market behavior that is measurable.  Why do some ideas move through markets and not others? His work does not account for the interesting advances in networking. It could be an issue of who starts the idea and the social network that exists with these idea generators. There are ways to advance this thinking, but not discussed in Shiller's book. 

Investors should be aware of narratives, themes, and sentiment, but awareness has to be at some point converted to something measurable. The use of word frequency has been applied to finance to measure the distribution of memes. When some narrative gets more frequency or play, there is a potential for increased demand. Still, the quality and importance of this link is mixed.  

Providing stories of narrative themes can tell us about time and place, but it tells us nothing on whether a given narrative will have an impact on prices or behavior. This could just be another way of adding history to economics. I can agree with the idea that more history and understanding of beliefs and sentiments should be explored, but there is a large chasm between descriptions and predictions.

Financial stress and Fed action - Is it needed?

First questions you ask for problem solving: "What is the problem to be solved?" Who has the problem?" 

So, what is the problem that is being solved with the massive purchase of Treasury bills by the Fed each month. The Fed works under a dual mandate of growth and stable inflation. In this capacity, they will serve as the lender of last resort in a crisis and provide for financial stability to help reach the dual mandate. Financial stability may be the third implicit mandate.

If there is financial stress, then the Fed may want to take action relieve the stress that may spill-over to the real economy. However, the measures of financial stress from the St Louis Fed and the Kansas City Fed are at or near all time lows. The Chicago Fed Financial Conditions Index is also near all-time lows and has been very stable. All are well below their constructed averages. 

Financing congestion and a spike in repo can have externalities on Treasury and short-term financing, but there has been now an extended repo program since September and a massive monthly buying program of $60 billion per month. This type of activity would suggest a massive financial stress problem.

This expected or perceived stress does not exist in the index numbers. It did not exist before September and does not exist today. There was a heightened level in December of 2018, but the lowering of rates seemed to have solved that problem. If the data indices are wrong or flawed, then they should be dropped. If they are useful, then policy-makers should at least take heed of their levels. 

Regulation and technical issues were the drivers of the repo and a solution of throwing money at the problem is not a fix. What kind of Fed guidance is given to the market when it is inconsistent their data? We have seen the result of Treasury bill buying, spiking of financial asset pricing. Once the buying subsides, we should know what will happen.  

Jim Simons' Guiding Principles for a Successful Organization

Jim Simons, the founder of Renaissance Technology, has a set of five guiding principles for a successful organization. While these principles are very general, it provides special insight into the mind of one of the great hedge fund firms. 

Doing the same things as other firms is never a good recipe for unique success; however, doing things different requires time and effort. A commitment to being different also requires a lot of smart people. You can’t be afraid to hire people smarter than you. Check your ego at the door because a special firm needs special people that have more talent than you. 

Success with building a business is about creating beauty in the sense of generating elegant simplicity, having a special core idea or process, and stripping away the excess to find the essence of what you are trying to create. You should describe your organization in one sentence. Forget the long mission statements and focus on a simple theme.

And, don't forget being lucky. Luck comes with hard work, but you need a boost at the right time. All these principles may sound cliche, but there is always truth in the simple cliches. The core issue is always learning to execute on these cliches. 

Expectations differ by generations - How do you deal with generational financial experiences?

• If you grew up during the Great Depression, you are always expecting the next Depression.
• If you were an investor during the Great Inflation, you will always be worried about the next great inflation.
• If you were a big investor during the Great Financial Crisis, you will also be worried about another crash.

I think you get the idea. There are generational events that will drive market expectations and behavior. The big events are usually negative because they are usually a surprise, occur over a short time, and cause significant anxiety. The big events have an imprint on our behavior through the availability heuristic. We then look for confirmation of events that these negative events will occur again. Some of these expectations will only change when that generation dies off, or in the case of investors and traders, no longer represent the majority of assets. 

Risk aversion is related to a number of investor specific characteristics: 

• Associated with lifetime experiences - Did you suffer or profit from a bad event (Financial Crisis, mortgages, tech bubble, LTCM, emerging market failures, etc...)?
• Associated with age - Did you investing life-cycle include these events? 
• Associated with past losses - Did you lose money in last crisis?

The challenge is learning to look beyond rare events, yet in reality, you cannot look beyond them because they have occurred. They are not possibilities but represent reality. Big tail events are a part of finance. We can minimize the look-back period to eliminate these outliers, but it does not change the fact that big negative tail events have occurred. 

The challenge for building any portfolio is identifying and overcoming potential biases based on these generational tail events that may not be as relevant in the current environment while at the same time accounting for reality. Some of the poorer performance of hedge funds may be associated with a decreased willingness to take risk given the tail events of the past. The closure of some funds may be associated with the manager's inability to reconcile his historical experience with the realities of today. The scars of the past bind the present.

Rare events should not be discounted to zero but have to be given their appropriate weight. Unfortunately, the weight for rare, but substantial events, is not a problem that is easy to solve. It is easy to say, give those tail events their due, but they may never occur again in an investor's lifetime. Yet, not accounting for them may generate financial ruin; the intersection between black swan theory and black swan failure.

Perhaps the greatest risk management issue is determining how to properly measure the uncertainty of low probability events of financial failure over a set horizon. What is the likelihood of a 50+% stock crash in the next three years? There are formulas to calculate likelihood given past crashes over some historical sample, but small changes in the problem set-up or looking at a shorter sample of history will give very different answers. More importantly, how should investors respond to different likelihoods of rare events? Should your behavior change if failure moves from .005% to .02%? 

A simple response is that it does not matter much because an investor should always protect against any event that has a minimum tail likelihood. Still, the response of what will be done with this information could be radically different based on who is receiving the information. 

Perhaps every firm should have a wide set of ages and experiences on their investment committee to offset or diversify generational event risk perceptions.