Quants focus on data and numbers. Forget any story or narrative and show me the data. Yet, a narrative often drives markets. Investors have to be aware of the current narratives that are in the market place because it can provide either a headwind or tailwind for market moves. The narrative can be consistent with the underlying data or it can be in conflict. The narrative can be driven by good economics or it can be driven by theories that have been popular in the past but have been debunked. Financial journalists look story that fit the facts nicely. Consequently, it is important to read the news to appreciate the current market narrative or storyline.
A current market narrative is that based on Shiller’s CAPE, the market may be expensive and that the current market has likely to run out of steam given its long upward trend. This may be true. It also is the narrative that is shaping expectations and behavior. Knowing that there have been more stories about overvaluations is relevant for making your next portfolio move. Similarly, the Great Financial Crisis (GFC) has often been compared to the Great Depression. The failure of banks in the GFC is narrative based on greed not poor policy choices. Again, this narrative may be true but it may also crowd-out alternative theories.
Interestingly, a driver for this discussion on narrative is Robert Shiller who recently presented a paper with the simple title, “Narrative Economics”. Shiller’s article is very wide ranging in its discussion, but plays on themes that has been his focus for decades, the potential irrationality of market behavior. When Shiller discusses irrationality, he is not referring to some extreme crazy behavior but the simple fact that narratives or simplified stories can lead to behavior that is false or overly simplistic. Narrative works through an economy no different than epidemics. The same type of models can be used to describe how narratives work through news. Shiller suggests a better awareness of the role of narrative on economic behavior and movement away from an over-reliance on quantitative modeling.