Monday, August 18, 2014

The Psychodynamics of the Stock Market

We think of stock market as an indicator of economic activity. But it is also an indicator of the emotions associating with investing, and more broadly with our shared images of the future. If the market signals our collective “greed and fear, these feelings only highlight that our experience of an unknowable future leaves us vulnerable to primitive emotions. This was the basis after all for Allan Greenspan’s, the chair of  the Federal Reserve Bank, famous speech in which he worried that the stock market, responding to the dotcom boom of the 1990s, was expressing “irrational exuberance.”

If we take this point of view, one presenting question is what emotional meanings can we glean from the stock market today? What might it tell us more broadly about the emotional current that underlies our hopes and fears about the future, not just of the market or the economy, but also of society more broadly?

There is little doubt that the market has been going up since the great recession. But what has been most worrisome is that the volume of shares traded has actually been falling. As the following graphs shows, trading volume has risen along with prices in the past, but since the Great Recession it has been declining, and markedly so since 2011.


Writing as early as  2012 The New York Times reported that, “Trading in the United States stock market has not only failed to recover since the 2008 financial crisis, it has continued to fall. In April, the average daily trades in American stocks on all exchanges stood at nearly half of its peak in 2008; 6.5 billion compared with 12.1 billion, according to Credit Suisse Trading Strategy. The decline stands in marked contrast to past economic recoveries, when Americans regained their taste for stock trading within two years of economic shocks in 1987 and 2001. This time around, the stock market has many more players, including high-speed trading firms, which have recently come to account for over half of all stock market activity. But even they, like all other major groups, have recently been doing less overall trading. ‘When you keep in mind recent history, this is kind of uncharted territory,' said Justin Schack, an analyst at Rosenblatt Securities.”

Ben Hunt, a colleague and a brilliant analyst of the stock market, writes that, "Since the outbreak of the Great Recession, with a few exceptional months marked by panic selling, trading activity in US equity markets has done nothing but go down. And when you take into account the growth of algorithmic trading and other machine to machine activity which now accounts for as much as 70% of daily trading volume, the decline in actual human beings buying or selling stock in order to acquire a fractional ownership share in an actual real-world company is much more dramatic. ( Hunt calls this the “hollow market,” bringing to mind T.S. Elliot’s great poem which ends with the famous phrase,

“This is the way the world ends,
This is the way the world ends,
This is the way the world ends”,
Not with a bang but a whimper.

In other words, he is suggesting that the market appears increasingly lifeless- the world is ending- yet it does so quietly. Prices are still high but interest and passion are absent.. I want to propose that we can characterize this financial lifelessness in four ways; "the search for safety," "feelings of dependency," "the decline of difference," and the "inward turn." Let us look at each one in turn. As I hope to show, these emotional descriptors correspond to measurable developments on the stock market. In this sense the market provides nuanced measures of of our collective emotional state.

Safety: Strikingly, traders have organized their buying and selling to feel increasingly safe rather than at risk. The Chicago Board Options Exchange markets an index called the ‘VIX’ that traders can buy and sell. The index is based on a weighted average of options contracts*(see footnote), that in turn is based on 500 stocks that trade on the  New York Stock exchange  and the NASDAQ. When the index is high, traders expect more volatility in the market. When it is low they expect less. It is therefore often called the “fear index,” since it measures the degree of turbulence and thus uncertainty in in the market. As the following chart shows, the level of fear has fallen significantly since 2009, and hence the corresponding sense of safety has increased 


The sense of safety matches the strength of corporate balance sheets in the economy at large. One measure of corporate leverage is the ratio of the corporate sector’s  net debt (debt minus its cash on hand) to its earnings. To use an analogy, one way to assess if a family is highly leveraged, and thus financially vulnerable, is to compare its debt relative to its family income. This measures the family’s ability to pay off its debts and not go bankrupt. In the prelude to the Great Recession many families had too much debt relative to their incomes. Currently, this ratio for the corporate sector as a whole, net debt to earnings,  has fallen by 2/3 since the beginning of the Great Recession. The corporate sector is not leveraged and companies in the main are not vulnerable to sudden downturns. They are safe. This is what we mean when we say that a company’s balance sheet is “strong.”  

Dependency: Stock Market participants increasingly focus on the Federal Reserve Bank (“the Fed”) and its likely decisions, to the exclusion of assessing the fundamentals of the different sectors of the economy, or the performance of different companies.  As Hunt argues, “Over the past five years an extremely powerful narrative has been created, what I call the Narrative of Fed Omnipotence – whatever happens in the market, for good or for bad, happened because of what the Fed did, not because of what happened in the "real" economy.” ( This is one result of the Fed’s historically unprecedented policy of creating enormous reserves in the banking system-- see the chart below -- so that interest rates, which measure the balance between the supply and demand for capital are close to zero. 


The Fed's primary purpose was to insure that all member banks had adequate cash, and that companies, the banks’ depositors, would not go bankrupt because their assets were illiquid. This was a sensible response to the cash crunch associated with the initial stages of the Great Recession. But one untoward effect has been to inflate the value of most stocks, irrespective of their individual performances, as investors search for ways to earn more than minimal interest on their cash holdings. In effect, the stock market goes up not so much because the business prospects for the future are good, but because there are few alternative ways to earn a return.

This argument suggests that stocks are in fact overvalued. Indeed, one way to assess its overvaluation is to the total value of all stocks on the market, what is called the market’s “total capitalization,” relative to the Gross Domestic Product (GDP), or total measured production. This ratio measures how productive our total wealth, the sum of all of our capital assets, is in producing the income we use every year to both consume goods and services, and to invest in the economy. To use an analogy, it is like measuring the value of a house relative to the annual rents it brings in. When this measure is too high relative to historical standards, we suspect that the home is overvalued, signifying perhaps a bubble in the real estate market. Its value is not consistent with the rents it brings in. 

As one analyst notes, the historical value of this ratio for the stock market, "total capitalization to the GDP," was .55 before the recession but is now 1.35. This(  This suggests that stocks like our imaginary house, are overvalued. Stock prices are not rising because companies are more productive, but rather because the Fed is supporting high prices.
The following graph shows this quite clearly. The ‘SP 500’ (Standard and Poor’s), an index of stock market performance, has been rising in response to the value of the total assets (bonds of many kinds)  that the Fed holds. But the Fed’s assets increase when, to give banks more money, it buys bonds from bank depositors, and deposit the cash in their accounts. The Fed owns more bonds and individuals and companies have more cash.


The decline of difference. One feature of the Fed’s impact on the stock market is that increasingly stocks move together rather than separately based on companies’ underlying differences. Modern portfolio theory, which lies at the heart of much investing practice,  sums up to a simple maxim, that to be successful one must not put too many eggs (money) in one basket (a stock). This means that investors should diversify their holdings by identifying stocks whose movements up and down are not correlated. But one impact of the Fed’s central role in shaping the market narrative is that stocks increasingly move in concert rather than on the basis of their distinctions. Dependency decreases differentiation.

In 2010 JP Morgan reported that “correlation between stocks are currently at the highest level.” In 2011 another analyst reported that, “My study of the behavior of S&P 500 confirms that correlation is running at record levels. The average trailing two-year correlation between the S&P 500 soared to 
about 60% in the fall. This is higher than during the burst of the Internet bubble or the 1987 stock market crash.” (  

This correlation is one reason for poor hedge fund performance. Hedge fund traders make their living by detecting differences, for example by anticipating that some stocks will go down while others will go up. As correlations between stocks and classes of stocks rise, it is harder for hedge funds to make money. As a Bloomberg, January 2014 news item reports, “Hedge funds trailed the Standard & Poor's 500 Index (SPX), a measure of the stock market, for the fifth straight year.”

 The Inward turn: There are two conceptions of how the stock market moves. We can call one the “fundamental” view, and the other the “sentiment” view. The former is based on investors’ assessments of the real profitability of companies and sectors. The latter is based on assessing what other investors think and feel about the market. Ben Hunt uses the analogy of the poker game. If you trade on fundamentals you are focused on the cards in your hand and what you think you know about the cards in other players’ hands. If you trade on sentiment you focus on what the other players might be thinking about their cards and your cards. Both perspectives are critical. The good poker player plays the players as well as the cards. Warren buffet is a fundamental investor who plays the cards, while many active traders, particularly those that monitor stock charts, are focused on what everybody thinks, and what everybody thinks everybody thinks. They play the players. Describing the market climate today, Hunt writes, “The market will go up because every investor will believe that every other investor heard what Famous Investor X said, and every investor will be forced to update his or her estimation of what every other investor estimates… That’s how the sentiment game works.” (
The stock market’s “flavor” is based partly on the proportion of these two strategies.

One hypothesis is that in a period when the Fed is the most powerful player and stocks moves up and down together, investors turn increasingly inward toward the stock market itself and away from economic reality. Opportunities to profit arise not because companies perform differentially, but because a trader has been able to intuit the intentions and moods of other traders. This is why it is so important for traders today to focus on the unemployment rate. If the rate falls, it may signal that the Fed, anticipating real-economy growth, will at long last stop buying bonds from the public. If they reduce their demand for bonds, bond prices will fall and thus the interest rates will rise, thereby increasing the attractiveness of bonds relative to stocks. So time to sell stocks. But if the labor participation rate, the proportion of all people who either have jobs or are looking for them falls, then the Fed, concerned that people are giving up looking for work,  might buy more bonds, further lowering the interest rate. So time to buy stocks. The most salient questions becomes, “What is the Fed thinking?” and "What are other investors thinking about what the Fed's thinking?" 

Now, here comes the inward turn, if everyone knows that everyone knows that everyone is paying attention to the unemployment rate, then everyone is dependent on how the Fed will parse its words in its next public statement and how this parsing will affect all investors, and how these investors will interpret what other investors are thinking. When the sentiment game dominates, investors' attention
turns increasingly away from the fundamentals. This represents a flight from reality. The inward turn also accounts for the centrality of business shows on television. The shows’ anchors rarely offer considered or thoughtful advice, they are paid to be flagrant. Instead, since everybody knows that everybody is watching these shows, they provide some insights into what everybody knows what everybody knows.

The Anti-work climate

If I were to describe a work group to you in the following way; its member seek safety, there is unusual dependence on a single leader, differences are only minimally acknowledged ,and group members focus inwardly on their own group dynamic rather than their surround, I think you would conclude that this  group is not prepared to work, that it lack’s vitality, and may be even characterized as depressed or lifeless.  Using group-dynamics theory, we would characterize the collective mood of such a group as “anti-work.” We mean by this that though the group has been called upon to ostensibly accomplish some work, its members act instead as if they were called upon to satisfy their leader, keep one another safe, or feel gratified by ensuring that everyone thinks alike. If we look upon the stock market as the collective expression of our relationship to the work we are called upon to do together --to invent new technologies, to build businesses, to produce products that satisfy customers -- we could say that the stock market is expressing just this mood of anti-work, this lack of belief in our ability to be productively engaged in economic life. Perhaps as the following chart shows, this is one way to interpret the growth in the number of people who are no longer employed and are no longer looking for work at all. 

It is striking in this regard that two mainstream economists, Larry Summers, ( the former Secretary of the Treasurer in the Clinton administration, and Paul Krugman the Nobelist and columnist for the New York Times, ( have both suggested that we may be facing a period of what they call “secular stagnation.” a more technical term for "lifelessness." In the spirit of Keynesian economics this means that however low the interest rate, investors and businesses cannot be induced to spend their money on capital goods, that instead, in their flight to safety, they prefer to hold risk-free treasury bills, even when the return on these bills is close to 0%, if not zero itself. 

But the presenting question is why do we face such a situation? It takes but a few minutes of reading MIT’s Technology Review or the magazine, Scientific American, to be impressed by the extraordinary technologies, that with sufficient effort and investment, await us in such areas as new biological drugs, nano-technology, quantum-computing, solar energy, nuclear fusion, Big Data, 3-D printing/manufacuting and agile robots. Why would an economy and society be stagnant in the face of such opportunities?  The current mood and the prospects for stagnation beg for an explanation, for an understanding of the social and psychological barriers we ourselves have constructed and that are now getting in our own way. 

* When a trader buys an options contract he buys the right but not the obligation to buy or sell a stock at  particular price, called the strike price at a specified time in the future, say 30 days. If in 30 days the strike price is below the actual price, and he now has the right to buy the underlying stock, he can make some money by executing the option and then selling the stock. If the strike price is at the actual price or higher, his contract expires, and he is “out of the money.” 



  1. If individuals and corporations are holding onto vast amounts of cash they could look to funding social, artistic and charitable causes -- Bill Gates, Mellon and Carnegie, Ford and Rockefeller as models.

    1. actually when people sell bonds for cash their net wealth has not changed. It is like moving your money from a savings account to a checking account. So the rich do not have more wealth, just more liquidity.

  2. Larry, I think this is a really fine piece of research, making current evidence and thinking about the state of the stock market comprehensible using psychodynamic thinking. I have several responses that might require a conversation to clarify, but here are a few for starters:
    1) I agree with your point about the "hollow market" signified by high prices but absence of passion. I would take it further and suggest this is evidence of a post-crash traumatised system playing it safe and hiding its spirit in the face of its greed having been shamed.
    2) Your evidence about the volatility index, or the "fear index" suggests that what I have described as the task of the banks and the markets to balance the emotions of fear and greed have swung yet again in the direction of fear. perhaps we should not underestimate the increased role of the regulators in both fining miss-sold financial deals as well as in heralding a new era of financial integrity and procedural scrutiny...and they have only just begun!
    3) I think your comment on dependency is worth reading the whole article for alone. The discovery of the capacity of central banks internationally to regulate inflation has created since the crash a context where the capitalist principle that equal information provides fair pricing, is totally undermined. Share picking based on research, let alone the value of specific sectors and individual company prospects get lost in the herd following the fed's moves. In this section you also suggest how market prices may be more responsive to the volume of institutional (banks, pension funds etc.) cash seeking a home that won't deflate value, than anything related to profitability. This leads nicely to your point on the decline of difference.
    4) The inward turn is a neat phrase for the retreat from the fundamentals of investment assessment (Buffet et al). It tends towards a closed system that from a psychoanalytic perspective echoes the defences described in pathological narcissism as a "Psychic Retreat" (see John Steiner).
    5) One of the key issues about these shifts in the role of the stock exchange that you do not explore is the political one. There is a move in political economies away from representative democracy towards the idea that electability depends on the technical competence of economic management to protect and enhance the livelihoods of voters. This is rather than any notion of elected members to the legislature representing the views and values of regions, localities and interest groups. This makes for a more centralised management of the economy rather than creating a context where viable investments and technologies work for people seeking employment, creative solutions and consequent social improvements.
    6) Together all these factors point to stagnation, retrenchment and survival by retreat to various forms of defensive dependent self-interest that you summarise under the "anti-work" heading. In your final paragraph you suggest seeking explanations from social and psychological barriers. To these I would add the need to analyse the political and economic context of these systemic relationships.
    Many thanks for this stimulating blog.
    Richard Morgan-Jones

  3. Well written stuff indeed.

    But I guess the fact is not that people 'in the market' behave ( read trade) irrationally with exuberance ( read irrational exuberance). In the first place 'irrational exuberance" does not really mean anything special. Market is fundamentally irrational and exuberance is almost always innately irrational. But neither 'irrational' nor 'exuberance' is necessarily emotional. An irrational guy may show exuberance without being emotional.

    I know, you are already grinning and itching to tell me: 'give me an example'...

    Well what about fools?

    Stupidity is irrational , but not emotional. A man with 'irrational stupidity' ( note how I am using these two words together like ' irrational exuberance') may do something which many in the stock market do. They act foolishly. They act with stupidity. These actions may or may not be driven by emotions like fear or greed. They may represent herd mentality

    One more thing... even if all people in the market are acting with emotion ( say fear) it does not sound rational to me when the comment is that all people together ( the market . or the segment of the market - the 'collectivity') is acting emotionally ( out of fear). Here the collectivity is like a herd, some in the herd may be charged with emotion, but most others who are fools, stupids, morons wanting to do something are just following the rest, perhaps the minority. So I am not sure if this could usefully be described as ' the mind of the collectivity'. There is no organismic essence in this phenomenon... this is perhaps a machine running neither with a head nor with a heart!!

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