New York—As new theories of finance challenge the orthodoxy of the efficient market hypothesis, new types of research are displacing traditional fundamental research. Nowhere is this more evident than in alternative research, which is incubating innovative new approaches to securities analysis.
The efficient market hypothesis, which asserts that markets are “informationally efficient”, has been the cornerstone of financial theory for the last forty years. In a recent paper published in The Journal of Behavioral Finance, Robert Prechter and Wayne Parker challenge the applicability of neoclassical economic theory to financial markets. The law of supply and demand, while useful in explaining the marketplace of goods and services, breaks down when applied to the stock market. “The Law of Supply and Demand gets flipped on its head in the financial markets,” Prechter observes. “As a stock’s price rises, demand for it tends to increase. When prices are cheap, few want to buy. This is exactly the opposite of what happens in the butcher shop or the shoe store.“
Prechter’s paradigm is ‘socionomics’, which posits that financial decisions begin at the neurological level and extend to the behavior of social aggregates. “In finance, uncertainty about valuations by other homogeneous agents induces unconscious, non-rational herding, which follows endogenously regulated fluctuations in social mood, which in turn determine financial fluctuations. This dynamic produces non-mean-reverting dynamism in financial markets, not equilibrium.” In other words, herding behavior drives markets, which in turn drives economic events, not the other way around. Neoclassical economics has long recognized that the stock market is a good predictor of future recessions, but did not offer any explanations why this is the case. According to Prechter and Parker, markets predict recessions because the behavior that spawns bear markets infects the broader economy, causing reduced consumer demand and production.
Investment research reflects the shifting paradigms of financial theory. Fundamental research, like the efficient market hypothesis, assumes that markets are rational. Fundamental research rose to prominence concurrent with the efficient market hypothesis, and has dominated investment research for the last forty years. Increasingly, as new finance theories question the status quo of efficient market theory, so too alternative research methodologies challenge the orthodoxy of fundamental research. As Mukul Pal, head of alternative research provider Orpheus Capital has put it, “An alternative model of research is already thriving in the US, and it’s only a matter of time that it is accepted globally. The new capital market research model should be different from the old one and clarify some broad misconceptions of traditional research.” The king is dead, long live the king.
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to read a copy of “The Financial/Economic Dichotomy in Social Behavioral Dynamics: The Socionomic Perspective” by Robert R. Prechter Jr., Wayne D. Parker