Irrational exuberance

“I hope that the first behavioural economics project of this Centre would be to explain to me why as the economy is going down and down and down, the stock market is going up, up and up...” This was former chief economic adviser Arvind Subramanian speaking at the recent inauguration of the NSE Centre for Behavioural Science in Finance, Economics and Marketing, IIM-Ahmedabad.

He has not been alone in his failure to understand this anomaly. Clearly, other experts too are baffled, so much so that they are unable to come up with plausible explanations for the way the Indian stock market has been behaving lately. The closest one has been able to offer by way of a rational explanation is the liquidity factor, ie the reality of a liquidity-driven boom as opposed to fundamentals-driven one — too much money-chasing, too few goods, resulting in inflation. Ever since Indian bourses were thrown open to foreigners, liquidity-driven crests and troughs have been common. Enter Indian mutual funds, and the market turned more frenzied. Foreign capital thronging India enticed by greater returns is another rational explanation, but not enough to satisfy sceptics. It is little wonder they are seeking answers from the surreal world of behavioural science.

American financial literature already gives a peek into investor psychology, with the famous ‘irrational exuberance’ quip by former US Federal Reserve chairman Alan Greenspan coming readily to mind. In 1996, he spoke almost prophetically about the impending ‘dot.com bubble’. People do get carried away — more so investors, notorious for herd mentality, especially when panic-selling grips the market.

Another irreverent American quip is ‘there is a greater fool out there’. It simply means no matter what price you pay for a share, you would be able to sell it sooner or later at a higher price, as there would be a greater fool in the market. But, this theory doesn’t hold when panic grips the market or a particular scrip. While a rise is slow and gradual, a fall tends to be rapid, so the one who clings to investments despite the slide becomes a laughing stock. Wisdom lies, in such circumstances, in cutting losses. Time-honoured stock market behaviour is exiting in droves — a fund manager’s nightmare.

Missing the wood for the trees is another behavioural aspect of the market. The Sensex basket contains but 30 shares, albeit from different cross sections of the industry. Yet, we tend to extrapolate the Sensex performance to the entire market. In the recent rally, only eight of the 30 companies were heavily patronised by buyers, pointing to the irrationality of even pedigreed foreign institutional investors; they could not to shake off a basic human trait — herd mentality.

It is not as if all the behavioural aspects of the market are rooted in negativity or irrationality. A highly rational trait became discernible ever since derivatives trading was allowed and became rampant in the Indian bourses; that is, viewing the twin trading platforms — cash and derivatives — as an arbitrage opportunity. Buy in cash and sell in derivatives, and vice-versa. In addition, the small size of upfront investments in the derivatives segment is attractive to many investors, so much so that last year, the derivatives to cash segment investment ratio stood at a mind-boggling 29.6:1.

Subramanian has offered to travel to India should someone were to offer him a behavioural explanation for the dissonance between macro economic indicators, and the Sensex. He need not, because behavioural science has always lurked in the background. Yet, it would be presumptuous to rule out a more coherent explanation for the economy-market paradox.

The writer is a Chennai-based chartered accountant