Narratives Matter, Until They Don’t: Introduction to the Intersubjective Markets Hypothesis
“Confronted by a reality of extreme complexity, we are obliged to resort to various methods of simplification: generalizations, dichotomies, metaphors, decision rules, and moral precepts.” – George Soros
Finance is teeming with beliefs about how the economy works and why asset prices fluctuate.
For years, we have been told that equities are going to the moon because of unconventional monetary policy. A quick glance on social networks, and more particularly on the comments section, shows us that a lot of people (from specialists to the average Joe) are firmly convinced that the expansion of the Federal Reserve’s balance is the main cause of risky asset hyperinflation in the United States.
Unfortunately, that is not true, and everyone knows that correlation does not imply causation. In fact, if quantitative easing was a main driver of stocks performance, then the Nikkei would have outperformed any other index for years.
Besides, assets purchase programs by central banks do not necessarily lead to price appreciation, as evidenced by the “Mississippi bubble” in France. Indeed, when the shares of the Mississippi Company stared to collapse in 1721, the Banque de France governed by John Law decided to step in and to buy shares in order to stabilize the market. That kind of “equity QE” program is the ultimate dream of many people on Wall Street, and that it is exactly what the French central bank did at that time. However, people might be shocked to learn that prices continued to crash towards zero despite that intervention.
The reason is quite simple. If most people are convinced that an asset is worth nothing, then it does not really matter whether a big institution like a central bank is willing to buy it or not.
In other words, the current impact of QE on capital markets is mainly due to the perception people have of the link between monetary expansion and the market, even though that link is the product of collective beliefs. Therefore, we can have a liquidity crisis even with an ultra-dovish Fed.
Dealing With Simplistic Assumptions
Before going further, it is interesting to focus on the so-called relationship between interest rates and financial valuation, as one may argue that low rates structurally imply higher market prices. Every market professional has (or should have) heard about valuation models based on discounted cash flows or dividends. The underlying idea is quite straightforward: the current price of a bond or a stock is said to be the sum of the present value of future cash flows that the asset will generate.
But things are more complicated than that. Such a formula should be regarded as equation. And this equation literally means that if you invest a certain amount of money today at a constant compound annual growth rate, after a while you will get the same amount as if you had reinvested cash flows generated by your investment using the same interest rate. Said differently, this popular equation holds true IF AND ONLY IF two conditions are met. Firstly, you must anticipate the level of cash flows that the issuer will generate in the future. That should not be a problem for fixed income securities, but that is a different story for equities. Secondly, interest rates must remain constant over time, which is a very restrictive assumption.
Thus, the relationship between such models and market prices is not necessarily reliable. But remember that what matters on capital markets is the fact that investors do believe that low rates imply higher valuations, not the veracity of this statement. Every day, we hear that the housing market is getting more affordable because rates keep dropping, while every serious economist know that the affordability index has never been so low in many developed countries.
The Intersubjective Markets Hypothesis
Thus, the question of narratives is essential to understand how people interact on financial markets and how collective trades are formed. Beyond economics, research in anthropology has shown that intersubjectivity is the pillar of our societies, differentiating humans from any other animal species. Without intersubjective ideas, it would be impossible for us to form groups larger than 150 individuals. There will be no religion, no state, no law, but also no economic activity, no money, no capitalism, no company, and a fortiori no stock exchange. Those ideas were well synthetized by Yuval Noah Harari in 2016 in Sapiens: A Brief History of Humankind .
In a paper published recently by the Journal of Interdisciplinary Economics (see the full version here) , I detailed how intersubjectivity applies to finance, putting forward the concept of “market narratives.” Indeed, markets are all about intersubjective things, such as “bulls” or “bears.” More interestingly, how participants interpret the news and how it affects market movements is very important because those narratives may influence further investors and thus impact future prices. From a scientific perspective, narratives can be regarded as the subtle result of a storytelling that spreads among the population of investors like “a meme machine.”
Markets and Darwinian Evolution
Before going further, it is worth talking about the “adaptive markets hypothesis” proposed by MIT professor Andrew Lo in 2004 . According to Lo, principles of species evolution should be applied to financial interactions: competition, selection, and above all adaptation.
Participants of a marketplace face a changing and selective environment, meaning that they are forced to adapt to the new conditions. Their environment evolves because of structural changes affecting the economy, politics or technology.
Nevertheless, I argue that narratives are the main source of instability of capital markets. Said differently, investors do not necessarily try to adapt to changes in the economic fundamentals, but rather to changes in the dominant narratives.
Although there are some links between the two, a narrative may differ significantly from economic fundamentals (in case of any doubt think about the “buy the dip” narrative). This explains why financial variables are unbounded and can reach extreme levels whatever happens in the economy, as evidenced by the unexpected bullish impact of the COVID-19 pandemic on most risky assets.
Chaos and Avalanches
While chasing a narrative seems to be the natural response of investors motivated by survival, it is important to bear in mind that this intersubjective framework should be thought in terms of “punctuated equilibrium,” meaning that markets spontaneously self-organize around dominant narratives until the new metaphysical order collapse.
The name for that is self-organized criticality, a concept that was introduced by Danish physicist Per Bak in the 1990s . As already mentioned in previous posts on this blog, self-organized criticality is common to various systems such as seismic activity, solar activity, epidemics, species evolution and of course financial markets. The underlying idea is the fact that those systems self-organize towards critical points that work as attractors, before being suddenly disorganized because of catastrophic events also known as “avalanches.” On capital markets, volatility spikes might be the real markers of avalanches, meaning that they are similar to earthquakes, floods, or species mass extinction.
The Trend Is Your Schizophrenic Friend
All that being said, the intersubjective markets hypothesis has two main implications for investors.
The first one is that the only way to outperform indices in every bull market is to be able to quickly adapt to the new narratives. Of course, that does not mean that investing with discipline like Warren Buffet is a bad idea. Developing a process based on rigorous fundamental analysis always pays off in the long run, but there is no guarantee that such a strategy will beat benchmarks under all circumstances, as evidenced by the serious underperformance of value funds since 2012. Thus, from a business perspective, being adaptive can be a necessary condition to survive on a highly competitive environment.
The second implication is that an adaptive process will not always be sufficient as one day or another the dominant narrative is likely to be seriously challenged, leading to high volatility conditions and fait-tail events. The problem is that it is difficult to anticipate those transitions phases, while their impact on the system can be significant.
Interesting work has been achieved by econophysicists led by French professor Didier Sornette  since the 1990s in fields like bubble detection (e.g. the log-periodicity power law singularity model). However, anticipating the end of a bull run is still difficult despite encouraging results (see It is All About Fractals – Tech Stocks and The LPPLS Model).
Today, people keep saying that you should just “ride the bubble.” The only problem with this claim is the fact you are likely to be trapped when it comes time to close your positions (i.e. when the dominant narrative is no longer valid).
My feeling is that you should only try to climb K2 if you know how to deal with altitude sickness and with the descent. Otherwise, you are just a candidate for the next big disaster.
Regulators: “Where Is My Mind?”
The last implication of the intersubjective markets hypothesis is the role played by regulators. We have seen for the past two decades that narratives can lead to extreme distortions in the economy. In theory, financial authorities like the SEC or the Federal Reserve should be careful that such things do not happen, as speculative bubbles are a threat to the economy and to social stability.
Against all odds, major central banks like the Fed or the ECB have decided to do the exact opposite, as they have been feeding dangerous narratives for years, doing whatever it takes in terms of propaganda to make sure that investors convince themselves that prices will never fall again (see Perseverance: Looking for Signs of Free Market Activity on Earth).
Time will tell if this was a good idea. But history already seems to prove the contrary.
 Harari, Y.N. (2014) Sapiens: A Brief History of Humankind. Harvill Secker.
 Bocher, R. (2021) The Intersubjective Markets Hypothesis. Journal of Interdisciplinary Economics.
 Lo, A.W. (2004) The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective. Journal of Portfolio Management.
 Bak, P. (1996) How Nature Works: The Science of Self-Organized Criticality. Copernicus.
 Sornette, D. (2003) Why Stock Markets Crash: Critical Events in Complex Financial Systems. Princeton University Press