Investor beliefs shaping market narratives and aligning our beliefs with market realities.
Election results, union budget announcements, monetary policy decisions, regulatory actions, the onset of war, and geopolitical tensions are select events capable of instigating significant attention-grabbing price movements in the stock market. These events move markets because investors believe them to be pertinent. Investors’ reactions, propelled by their perception of the implications of market events on stock prices, cause these significant price movements.
Firstly, market events need to be unexpected to trigger large price movements. Large price actions are unlikely if the event or action was expected because, by then, investors would have already evaluated the expected event’s implications for stock prices and taken appropriate action. Unexpected market events cause sudden large price movements in the market.
Belief System
But how does an investor arrive at her perception of the impact of market events on stock prices? Also, how does she form expectations about an event’s outcome? The answer to both the questions is… beliefs…
Her beliefs guide her in forming her perceptions and expectations about market events. She buys stock when she perceives an unexpected event as positive. A large spike in stock prices happens when a vast swath of investors believe, perceive, and act similarly. Therefore, it is not reality but instead the prevailing dominant beliefs that drive stock prices, and it is not necessary that those beliefs accurately reflect reality.
Most of the time the beliefs driving stock prices are true, but sometimes they aren’t. Since beliefs once formed are difficult to change, a market driven by false or irrelevant beliefs could stay detached from reality for a long time… although not forever…
Beliefs formed through reason and insight are likely the most effective, whereas beliefs based on emotions, predominantly greed and fear, are the most harmful for investors. A casual, unintentional mind is a fertile ground for emotion-driven beliefs. Only a deliberate mind could generate beliefs based on reason and insight.
Occasionally, we observe stock prices reacting in opposite ways to the same kind of market event at two different times. One plausible explanation for such divergent behaviour is that each time, different contrasting beliefs dominated investors’ minds, and so we had widely different interpretations of the two similar events.
In some ways, this is hopeful because it proves that our belief systems aren’t rigid. Through deliberate effort, investors can drop their wrong beliefs and adopt true beliefs such that their belief system is more attuned to market and economic realities.
Being a better investor requires our beliefs about how markets and investing work to accurately reflect market realities and be agile in a changing market environment. This is easier said than done because we are unaware of most of our beliefs as they reside in our unconscious. However, though unconscious, they strongly influence our attitudes and behaviours. Therefore, rather than contemplating our beliefs, a better way to make sense of them is by monitoring our attitudes and behaviours in various situations.
Market Narratives
Market narratives are subjective interpretations of related market events based on the interpreter’s understanding (and beliefs) about financial markets. It is very unlikely that only one narrative exists at a time because that requires all interpreters to have identical belief systems, an implausible and unrealistic possibility.
None of these narratives is likely to provide a perfect explanation for what is happening, because they are based on human understanding of financial markets. Even though our knowledge about markets has significantly advanced over the past several decades, it is still limited: our ignorance far exceeds our understanding. Moreover, forthcoming novel events or experiences could turn many of our present understandings into misunderstandings.
But at any time from the many existing narratives, one narrative gains command, and stock prices are always driven by this commanding narrative. The commanding narrative doesn’t have to be the most realistic one. Instead, the commanding narrative most likely caters to investors’ sentiments, desires, and interests.
Initially, the dominant narrative may align with current economic conditions and resonate with investor sentiments. As stock prices start moving according to the commanding narrative, the narrative’s credibility increases, and it gains more followers. Stock prices rise if the commanding narrative is positive. Prices gain further as the narrative gains more followers due to its increasing credibility. Conversely, a negative commanding narrative pushes stock prices down, and the more followers it gains, the more the prices are pushed down.
Changing economic conditions might make the prevailing commanding narrative irrelevant. However, investors still cling to the narrative despite its irrelevance, as time has deeply entrenched it in their psyche, making it difficult and painful to let go. Moreover, why should they let go of a narrative that has served them well for so long?
Therefore, investors largely remain oblivious to any competing narratives, even if they are more relevant to the changed economic conditions. Consequently, stock prices move according to the old and irrelevant narrative. However, investors can’t remain intransigent to market realities forever. There comes a point when market realities overwhelm the old narrative’s hold on investors’ psyche such that letting go is the only alternative for investors.
It begins when stock prices stop behaving according to the old narrative because the narrative isn’t gaining new followers enough to move prices. The old narrative fails to attract new followers because investors are drawn to alternative narratives that align more closely with current economic realities. Sooner or later, the old narrative loses command, and the market enters a period of uncertainty, characterised by volatile stock prices.
After a short limbo of volatile stock prices, a more convincing (could be realistic or not) narrative takes hold of investors’ minds, which will determine the market direction going forward. The new commanding narrative could be either positive or negative. Generally, narratives have a cyclical pattern: a negative narrative usually follows a positive narrative, and vice versa.
An effective investor should be aware of the market’s commanding narrative but not driven by it. He should be humble, agile, a sceptic, and a contrarian so that his belief system remains highly attuned to changing market and economic realities.
Market narratives don’t necessarily change alongside changing market realities, specifically, those narratives that have existed for several decades. Sometimes new market narratives might emerge that transform market realities. Other times new market realities aren’t impactful enough to change prevailing market narratives.
There is a reciprocal relationship between market narratives and market realities, and stock prices are influenced predominantly by market narratives. Hence, for effective investment decision-making, what matters isn’t the changing market realities but how those changes could transform or reshape the prevailing market narrative.
As a commanding market narrative drives the general market, individual stocks could have unique narratives, moving their prices accordingly. The market narrative might have the greatest impact on individual stock price movements in the short term, but the individual unique narrative prevails in the long term. Some stocks have no narrative at all – neither positive nor negative – and thus their price movements are fully subservient to the market narrative.
Interpreting stock price movement relative to its business fundamentals and economic performance is the best way to make sense of the prevailing narrative. The following case could illustrate this: Stock X has underperformed the market over the past five years due to poor earnings growth, and thus, trades at a low valuation.
However, a new positive narrative emerges for Stock X due to a recent revival in its earnings growth and its price rises. The narrative now looks like this: improving earnings growth driving the low-valued Stock X higher. The stock price rises alongside high earnings growth for two years.
However, despite high earnings growth, the price stops rising after two years. This strange behaviour of the stock price could be construed as the waning relevance of the prevailing narrative. Because, according to the prevailing narrative, the stock price should rise with high earnings growth. Another possibility is that the narrative is still in command, and the stock might just be consolidating after a long rise. Only an experienced and attentive investor could comprehend the difference.
Conclusion
Market narratives drive stock prices. We interpret market events based on our belief systems, which, in turn, shape these market narratives. Only a belief system subjected to constant and rigorous validation could interpret market events accurately.
An unattended mind is a fertile breeding ground for inaccurate beliefs, formed based on emotions, self-interests, or misunderstandings. Moreover, changing economic conditions might make once-relevant beliefs irrelevant. Only a deliberate mind could form beliefs based on understanding, and thus, is more likely to have a belief system more attuned to market and economic realities.
Most importantly, beliefs are contagious: they spread from one person to another through social interactions. Most investor beliefs are shaped by social contagion, meaning we believe whatever we read and hear from others without validating them. Beliefs catering to emotions and self-interest are more contagious than those based on understanding. Therefore, the prevailing market narratives are most likely to be shaped by such beliefs.
Good investors should be aware of the prevailing market narrative and its underlying beliefs but never be driven by them. Great and successful investors are those who in addition to being aware of the prevailing market narrative can decipher an alternate narrative more reflective of economic realities and use the discrepancy between the two narratives to their advantage.
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