'Greater fool' theory could be fooling us all

Jul 28, 2019

Simon Bishop


What does a Swedish study about psychological biases have to do with the state of financial markets? The answer: More than you might imagine.

Financial markets are stuck in a strange paradox where central banks are turning more negative about the world's economic prospects but equity markets are rapidly climbing to new all-time highs.

What's behind this "twilight zone" in financial markets?

NERVES GROW

Central banks around the world have clearly grown more nervous over the last six months.

Most prominently, United States Federal Reserve chair Jerome Powell signalled he was prepared to cut interest rates when the Fed next meets on Thursday.

Mr Powell said on July 10: "It appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the US economic outlook."

Other central banks have also warned about the health of the global economy.

Bank of Japan governor Haruhiko Kuroda warned in late May that he has become increasingly nervous about economic prospects, pointing to a high degree of certainty and "large" downside risks.

The European Central Bank (ECB) has also made clear its concerns.

ECB president Mario Draghi said back in April: "The persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets appear to be leaving marks on economic sentiment."

STILL PUMPING

Despite the warnings from central banks, share markets around the globe are still climbing higher.

In the US, all three major indexes - the Dow Jones, S&P 500 and Nasdaq - have all reached new all-time highs this month.

In Japan, the Nikkei 225 is only 10 per cent from 28-year highs while in Germany, the DAX is only 8.5 per cent from all-time highs.

Seemingly, all of these share markets are happy to ignore the warnings from the world's most respected central bankers.

CENTRAL BANKS 'DON'T UNDERSTAND'

Reserve Bank of Australia governor Philip Lowe complained last month that he didn't "really understand" investors.

In his view, there are investors who think the outlook is sufficiently weak that they expect central banks right around the world to cut interest rates but are not worried about corporate profits or credit risk.

Mr Lowe said that it's a "strange world" that sees markets climbing on hopes for interest rate cuts.

So why do markets keep going up even as central banks warn about the growing negativity in the global economy?

WHO'S FOOLING WHO?

The reason might be in part explained by an infamous University of Stockholm survey published in 1981 by psychologist Ola Svenson.

The report found 88 per cent of Americans (and 77 per cent of Swedes) believe they are "above average" drivers.

If 88 per cent of Americans are better-than-average drivers, where are all the bad drivers? The simple answer is that drivers - and market participants - overestimate their abilities.

So, despite the risks ahead, many market participants believe they will be able to enjoy the short-term gains but exit their positions before the market turns.

In markets, this is famously referred to as the "greater fool" theory. You sell your risk-prone investment to an even greater fool than you.

WARNING

The greater fool theory might explain why markets have continued to climb even as economists and central bankers warn about the economic outlook.

If this is the reason equity markets are still climbing - that investment professionals know the economic story is worsening but believe they can get out before the market turns - then it suggests that the risks are growing as we enter the second half of 2019.

WATCH THE MARKET

Even more concerning is the fact that if markets aren't currently responding to economic data, how do we try and gauge what might happen next?

Perhaps in an overheated market cycle, the best way to look into the future is to look at the most "risk-sensitive" parts of markets.

These more risk-sensitive parts might include areas such as gold - which can rise during times of fear as it is often seen as a safe haven - or copper, which might fall as economic demand dries up.

Alternatively, a move higher in safe-haven markets like the Japanese yen and US bonds might also be a warning signal.

With central banks becoming more nervous about growth and the risks for markets, perhaps we need to be as well.

• The author is corporate hedging director, Apac, for Western Union Business Solutions.