‘Is it safe?’ This can be a torturing question, particularly if you don’t understand what it refers to, as was quite literally the case for Dustin Hoffman in the infamous dental scene from the 1976 film Marathon Man.
For today’s investors there is real confusion that assets which were previously regarded as ‘risk-free’ - such as sovereign bonds - have lost their safety blanket, leaving investors in the cold.
Apart from the pain of financial loss, this raises deeper concerns, not least for modern finance theory, which places the ‘risk-free rate’ at its very foundations.
In the context of the ‘market’s mind’, what are the consequences of being denied the usual relief in knowing that an investment is safe, whether through lack of transparency, redrawn rules or shifting regulations? What if, for example, the market can no longer make sense of how the properties of one type of security - such as a credit default swap - relate to the properties of another - such as sovereign debt.
By ‘sense’ I mean not only the physical characteristics, such as legal ownership, but also the sensations involved in having positions in these securities. This is what the mind sciences call ‘the binding problem’, which is the issue of knowing how to assemble the properties that are detected in separate specialised detection centres in the mind into a coherent whole. In terms of the market, we can think of those detection centres as the individual markets for equities, bonds and other assets, spread around the world. These centres, through their participants, determine the risk and return profiles of those assets, which include the intrinsic qualities attached to owning the assets. Like an overlay, these qualities of assets reach over and above any rational assessment of their utility. Specifically, the feeling of trust is what makes safe assets ‘safe’. The fact that our modern financial system is based on fiat currencies - which are not backed by physical assets such as gold - further underlines the importance of trust. It also hints at the system’s vulnerability.
This phenomenal dimension of investing is exemplified by popular terms such as ‘mood’ and ‘sentiment’. What is less understood about these collective - and frequently contagious - psychological states is that they escape traditional investment research methods. The type of knowledge one gains by experiencing trust, despair or exuberance is different from the type of knowledge one gains by fundamental, technical or quantitative analysis. Specifically, market sentiment indicators such as the bull-bear spread, put/call ratio or the ‘fear gauge’, do not convey the intrinsic qualities I highlighted above i.e. what they ‘feel like’. I believe that traditional analytical methods completely fail to describe the patterns we try to uncover, just as an analysis of a piece of music fails to convey how it sounds. Still, we can complement any analytical knowledge by mining such sensory information contained in market data. But this can only be achieved in a way which appeals to the mind’s non-analytical or intuitive detection centres. This requires a different research method, which I will discuss in a future paper.
For now, what I believe is relevant in answering our torturing question is that ultimately prices are the conductors of qualitative market states, just as musical instruments conduct sound. It is through prices that the market mood is experienced. They convey, symbolically, how we deal with risk that is immeasurable (‘Knightian uncertainty’), not only rationally but also emotionally.
And here we have arrived at the Marathon Man as a metaphor for the sovereign debt crisis. The political elite, such as the central bankers, are using very crude tools to extract information from the markets on a question that is no longer clear. Moreover, the cognitive attempts to make sense of, and possibly answer, the question are accompanied by the sensation of drilling for that information. And although in Marathon Man Laurence Olivier drills without an anaesthetic, arguably US Federal Reserve Chairman Ben Bernanke is providing too much of the stuff.
To conclude, years of subsidies, guarantees, off-balance sheet transactions, and other distortions have recently been joined by such tools as quantitative easing, currency interventions and short-selling bans. The ultimate unintended consequence of such price interference is that it overrules the psychophysical laws. Under free and open conditions, the latter allow true price ‘discovery’, with prices bridging the mental domain of our collective psyche with the physical domain of the real economy. Healing the mind of the market looks a long way off.
