The past two years have proved an unbelievable market roller-coaster ride for investors, traders and sovereign governments. The financial markets, which were rocked to their very core by scandal and crime, have become a favorite topic of conversation among the least likely people. Economists are treated like rock stars, filing auditoriums and juggling visits to CNBC, Bloomberg and MSNBC. Their opinions are sought after then dissected, and often dismissed if they don't give the right (positive) answer. The Efficient Market Hypothesis has been questioned and criticized. After all, how can markets be efficient if they tumble by 50% seemingly overnight? Was it efficiency that wiped out pensioners' savings and turned hundreds of thousands of homes into a liability to be walked away from? Market bubbles are not efficient are they? Yes and no. A theory has been proposed by Dr. Andrew Lo of MIT's Sloan School of Management, called Adaptive Market Hypothesis. He uses neuroscience and psychology to help explain why markets do what they do. Essentially his theory is that the origin of all financial bubbles and busts are fear and greed. I agree wholeheartedly. And I propose a simpler theory that one can use to explain to non-finance types how markets work. There are clever people (let's call them hedge funds and investment banks), and there are stupid people (let's call them us). Both sets of people are greedy. The clever people want to make more money for their employers so that they get a bigger bonus and buy more stuff. The stupid people just want to have more stuff and prefer not to have to work too hard for it. So the stupid people invest their money in markets that the clever people manage. The clever ones rake a fee off the top, then invest our money in things that we will never in a million years understand. Then the other clever clogs trade the same things, because if X bank is making money on it then Y bank will too! They make money (hopefully) by all trading the same things. Sometimes they trade them fast using their computers(high frequency trading). Sometimes they trade them slowly over the counter. They buy them and they sell them and then do it all over again the next day. Everyone is happy. Dr. Lo says that prosperity is like a anesthetic to the brain: “a drug-induced stupor that causes us to take risks that we know we should avoid.” Then - bang! The risks come home to roost, so to speak. The stupid people suddenly realize that they have too many loans for SUVs and ATVs and plastic crap for Xmas that they can't pay off. The clever people can't spin their way out of the trading tangle they invented. Panic sets in, markets crash. Governments get blamed. So governments dig deep and find gazillions (most overused word of 2009?) which they give to the clever people interest free. The clever people say: "Wow! Look at all this dosh. I can spin this and make gazillions more! Whooppee!" And they do. But wait. The stupid people are still living in debt, maybe have lost their homes, and don't have any jobs. How is that Adaptive or Efficient?
Again, to simplify - if the clever people get on with making money it will eventually filter down to the stupid people again. Businesses will get loans, companies will be bought out or merged. Banks will hire again. More bankers will buy more stuff and manufacturers will have to make more stuff. Then manufacturers will have to hire more people. Who will be able to buy more stuff. Do you get the picture? I call it the Greedy Market Hypothesis. Maybe 2010 won't be so bad after all.