It’s no surprise that I’m weary of conventional economic and finance theories.

Readers know that I’ve spent quite a bit of time arguing against both. As well as dedicating a lot of time uncovering practical theories that have been neglected by the mainstream.

But there’s one concept I came across recently that I think traders should know about. . .

I recently read a phenomenal yet-little-known book called A Crisis of Beliefs: Investors Psychology and Financial Fragility by Nicola Gennaioli and Andrei Shleifer.

Basically, the authors argue that over the last 60 years, economics and finance have been dominated by the Rational Expectations Theory (RET) and Efficient Market Hypothesis (EMH). Both claiming that “economic agents [people] are rational and form their expectations about the future in a statistically optimal way, devoid of emotions, given the state of the economy”.

I know reading that all sounds silly. But that’s what the academic’s believe. And that’s what they want us to also believe.

The problem – according to the book’s authors – is that history indicates there’s excessive optimism right before a crisis occurs, and that investors don’t properly gauge downside risk. . .

Putting it another way – people overestimate the likelihood something good will occur. And discount the likelihood something bad will occur.

This in behavioral economics is known as the ‘representativeness heuristic’. And it’s a human bias that many end up falling for.

Here’s an example: during the early 2000’s housing bubble, people believed home prices would keep rising. And that the chance for falling prices was roughly zero – but even if somehow prices did fall, things wouldn’t be that bad. (Looking back, home prices did start collapsing and things really were that bad).

The failure of modern economic theories to account for realistic expectations is a major handicap as it assumes away a huge source of instability – which is investors suddenly losing faith or having declining expectations.

This decline in expectations alone can trigger a sell-off – and even at times – a market panic (as history shows).

Think about it – if market participants suddenly realize the future may not be as good as they first thought – they’ll rush to get out while they can and with what they can.

This rush by the crowd sends prices tumbling as everyone’s selling and no ones buying. Drying up market liquidity. And creating a wave of dangerous trickle-down-effects (falling home prices, bank runs, bankruptcies, etc).

Famed billionaire trader George Soros understood the importance of expectations. He even based part of his ‘Theory of Reflexivity’ on it (one of my favorite trading tools).

“Reflexivity theory states that investors don’t base their decisions on reality but their perceptions [aka expectations] of reality. The actions that result from these perceptions have an impact on reality, or fundamentals, which then affects investors’ perceptions and thus prices. The process is self-reinforcing and tends toward disequilibrium, causing prices to become increasingly detached from reality. Soros views the global financial crisis as an illustration of the theory. In his view, investors assumed that on a nationwide basis housing prices would never decline. And as they came to believe a financial instrument made up of subprime mortgages, if properly packaged, could be as safe as their AAA credit rating implied, prices of those assets became detached from reality. This bubble eventually collapsed, resulting in the financial crisis…”

Another individual that understood the importance of investor expectations in the boom-bust cycle was Hyman Minsky with his Financial Instability Hypothesis (FIH). He studied how investors with high risk tolerance (heavy risk taking) will eventually lead them to risk aversion (avoiding risky things) – and vice versa.

This is because their optimism outpaces reality. But eventually something will occur – whether a war, a bankruptcy, or a recession – and then their pessimism will outpace reality.

Taking pieces from Soros, Minsky, and Gennaioli – we can see how important the cycle of expectations are to financial conditions and markets.

Now – I personally call these sharp shifts in expectations the ‘rubber-band snap’ – because once people suddenly realize things aren’t as they thought – it can have dramatic effects (for both asset prices and economic conditions).

For instance – just as optimistic expectations (bullish) push things higher – pessimistic expectations (bearish) will send things tumbling.

All this is why I think it’s important to understand where people’s minds are at (aka what they’re anticipating). It isn’t perfect, but it can help paint us the big picture and tell us where crowd expectations are at.

First let’s look at the Consumer Confidence Index (CCI). This is the monthly indicator that surveys households and their consumption, saving and general economic situation. The higher the rating, the better their outlook. The lower, the worse.

As you can see – the CCI has dropped like a stone since the third-quarter of 2018.

Making matters worse, the Business Confidence Index (BCI) – which surveys and measures the business sector and their outlook – also indicates trouble.

From these surveys, we can see that both consumers and businesses are expecting some economic sourness up ahead.

Or put another way – their expectations are weakening.

Of course this doesn’t mean things won’t change. Expectations are fickle things – they can shift very quickly.

But while traditional economic theories ignore these expectations – I think it’s very important we keep an eye on them. Especially since historically we’ve seen that they’re a huge source of potential instability.

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