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At one level it seems obvious that there must be a strong connection between economics and investing. After all, if this were not the case why are there so many economists who are gainfully employed in the investments industry? Is it not true that investing simply boils down to a call on the future fortunes of businesses, as well as the economics of the industries and the regions within which they operate?
Some market participants will indeed subscribe to such a theory. However, there are many others (such as Churchill) who will no doubt beg to differ.
Perhaps that's why economist jokes abound within the world of investments.
In the words of Peter Lynch, the celebrated portfolio manager who ran the Fidelity Magellan Fund up until his retirement at the tender age of 46 in 1990: "If all the economists of the world were laid end to end it wouldn't be a bad thing."
If there was one economist who did more damage to the reputation of his profession than any other from the point of view of the investment world it was probably Irving Fisher. This renowned monetarist is remembered for explaining the cause of inflation by developing the elegant Fisher Equation of Exchange.
Unfortunately, his credibility suffered when, a few months before the crash of 1929, he was famously quoted as saying that stock prices have reached "a permanently high plateau". Worse still, he tried to defend this position in subsequent years, insisting throughout the Great Depression that recovery was imminent.
John Maynard Keynes was a contemporary of both Fisher and Norman.
Would his endurance as an economist (his insights are taught at universities and followed by governments to this day) have anything to do with the fact that he undoubtedly also had a better understanding of the vagaries of the market than most of his peers?
For example, it was Keynes who came up with the immortal quote: "Markets can remain irrational longer than you can remain solvent." Fisher should have taken heed!
It was also Keynes who likened professional investment to competitions in which newspaper readers have to pick the prettiest faces from a number of photographs, the winner being the one whose choice most accurately reflects the average preference of all competitors.
As Keynes said in his seminal work The General Theory of Employment, Interest and Money: "... each competitor has to pick, not the faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.
"It is not a case of choosing those which, to the best of one's judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree, where we devote our intelligences to anticipating what average opinion expects average opinion to be." This famous analogy can be considered a forerunner of the field of behavioural finance, popularised by Daniel Kahneman and Amos Tversky half a century later (Kahneman won the Nobel Prize for Economics for his work in this field in 2002).
Put simply, the principles of behavioural finance hold that investors in the stock market will often make decisions that are not grounded in economic principles.
The reason for this is simple:
market participants are human beings and, as such, their actions are influenced as much by emotions as they are by reason.
Behavioural finance stands in stark contrast to the efficient market hypothesis (EMH) developed in the sixties by Eugene Fama. In terms of this theory, a discounting process determines stock prices - such that they equal the present value of expected future cash flows.
Based on this, stock prices reflect all information and are, therefore, supposedly "accurate" at all times.
The EMH is based on a number of simplifying assumptions: most notably, that all market participants are rational, profit-maximising individuals. And it is this very notion that is attacked by the behaviourists.
After all, human beings are normal rather than rational: they suffer from greed and fear and they sometimes get caught up in the hysteria of crowds. As a consequence, stocks will often be badly mispriced. Moreover, such overpricing or underpricing can indeed prevail for extended periods of time - resulting in an apparent breakdown in the link between economics and investing.
However, any reference to the mispricing of stocks is based on the assumption that a certain specific price level exists that can indeed be considered to be valid or accurate or fair. What would such a value be and how would it best be formulated?
For example, some people might say that a certain price:earnings ratio is "fair" for a certain stock in question, whilst others - believing in a more optimistically minded, growth-orientated approach to investing - might be prepared to pay up significantly for the same share.
Yet a third group may contend that the p:e ratio is not even a valid measure to begin with, preferring to focus on cash flows or some other measure of economic success. Such is the nature of a market.
This point goes to the very heart of economics: namely, the existence of markets as clearing mechanisms. In terms of first principles, and in the parlance of Adam Smith, the price of a product will be set by the "invisible hand" of the market at a level that ensures an equilibrium between supply and demand. In this case, reference to a "correct" price does indeed appear to be justified.
However, shares are not the same as goods, since shares are not consumed.
A share transaction has more in common with a bet between two punters:
where one believes that the price is likely to increase (or "outperform"), with the other taking the opposite view. In terms of this betting analogy, the share price merely acts as the odds on which they agree.
This may explain why equity markets are more volatile than the markets for most goods and services, where basic economic principles may appear to prevail to a greater extent. Stock markets are influenced by a near-infinite number of factors and many of these are probably not even considered (or well understood) by the vast numbers of participants.
These participants come from different parts of the world, they have very different cultural backgrounds and patterns of behaviour, they trade in different time zones and they do so for a plethora of different reasons. At the same time they all continue trying to second-guess one another (in a Keynesian, beauty contest kind of way) while forecasting nearly everything else that might or might not happen in the world.
Does all of this mean that there's no direct link between investing and economics, between the price of a share and its "real" value? No. It merely highlights the fact that the relationship between the two is not a simple, deterministic one.
In the same way that "par" suggests the most likely score when a professional plays any golf hole, the underlying economic fundamentals of a company form a basis for forecasting share price action. It's true that share prices exhibit tremendous volatility - but then so does the performance of golfers, who score considerably better than par during certain rounds of golf and much worse in others.
No discussion of the link between investing and economics can be complete without at least a brief reference to the theory of reflexivity, as explained by George Soros in The Alchemy of Finance. In simplistic terms, Soros contends that economic reality does not only influence market prices but that the relationship simultaneously also works in the opposite direction - ie, markets can in fact influence the events that they anticipate (which explains why markets may so often appear to anticipate events "correctly").
To mention but one example: cast your mind back to the height of the Internet bubble, a short four years ago.
At that time the stocks of companies in the technology sector were trading at exorbitant prices - simply because the majority of stock market participants seemed to agree that there was suddenly a different reality at work in the world and that most of these companies would succeed in a new economy.
Companies without any track record (and, with the benefit of hindsight, often even with dubious business plans) were therefore not only allowed to list successfully; in many cases they actually attracted huge amounts of capital that would "normally" not be justified. However, this capital allowed many of them to actually develop viable products and services, even if this happened some time after the listing - clearly a reflexive situation where stock market behaviour had a constructive impact on the underlying economics of an industry (rather than the other way around).
Of course, the technology bubble did not last - once again proving the old saying that the market is always right in what it does but not always when.
Another way of saying this is that, in the longer term, the fluctuations in the investment markets will ultimately reflect underlying economic reality.
Unfortunately - to quote John Maynard Keynes one final time - in the long run we'll all be dead.
