Riding the Equities Roller Coaster: How Rational Beliefs Lead to Crazy Markets and How You Can Profit from the (In)Sanity

By Jesse Czelusta (from the September 2002 issue of Index Rx)

Mordecai Kurz is an intense character. He spends many of his hours quietly working in a small office on the third floor of Stanford University's economics department. Encounter him in conversation, in front of a class of eager graduate students, or speaking to a group of fellow economists and you'll soon realize that this man possesses immense enthusiasm for economic theory. This enthusiasm is evidenced not only in the large demeanor that belies his diminutive physical stature; it is most powerfully reflected in his ideas. Kurz is the father of rational belief theory, perhaps the most important and sweeping idea to come from an economist in the past 30 years. And more to the point, you, the individual investor, can profit directly from this theory.

The core of rational belief theory is simple and elegant: "the rationality of expectations of an agent at any date should stipulate that his belief cannot be contradicted by past data generated by the equilibrium of the economy." In other words, hold any belief you like; as long as this belief is not contradicted by past or present reality, you would be considered rational under rational belief theory. Believe that prices will go up, or believe that they will go down in response to any given event. Believe that God exists or believe that He doesn't. Believe that the stock market will go up given today's news, or believe that it will go down. Even if the world's brightest economist comes to an opposite conclusion, you're considered rational under rational belief theory unless something happens to disprove your view. For example, rational people before the time of Galileo could have believed that the sun revolves around the earth, but after there exists irrefutable evidence to the contrary, you would have to be irrational to hold this view.

All economic models (and predictions) are based upon some definition of rationality. Rational belief theory provides a natural definition for situations involving movement through time.

To better understand what rational belief theory contributes to our understanding of economic phenomena, consider the following: While most academic theories find life only when some obscure soul opens the pages of a musty journal, one need simply read the financial headlines to see the relevance of rational belief theory to the real world. Take, for instance, the following up-and-down sequence of headlines from TD Waterhouse's weekly email publication, "The Outlook:"

June 16, 2002: "See Pressures Easing Soon"
June 24, 2002: "Stuck in Reverse"
July 15, 2002: "See Rebound Soon"
July 29, 2002: "More Testing Likely"
August 8, 2002: "Struggling to Gain a Foothold"
August 15, 2002: "Add to Stock Holdings"

Without rational belief theory, economists have to resort to contrived assumptions to explain such predictive schizophrenia. After all, rational expectations theory, the dominant theoretical paradigm and the basis for efficient markets theory, begins with the premise that all players know the true structure of the economy; that is, everyone knows exactly how prices will behave under any conceivable contingency. Thus, barring continual and significant flows of unexpected yet important information (which, for the most part, did not appear to be present from June 16 to August 15), everyone should have held exactly the same view about the direction of the stock market and this view should have been stable.

Or consider the fact that every day millions of people who are nearly identical with respect to their investment goals and their tolerances for risk trade stocks with each other. While this happens so often that we don't even think about it, such behavior is a real puzzle for the rational expectations theorist--after all the buyer must believe that the stock is on its way up and the seller must believe that it is on its way down (relative to other investments).

While it seems absurd to non-economists to assume that everyone possesses near-omniscience, the fact of the matter is that rational expectations theory is, even today, ubiquitous. This may change. What Kurz has done is given us a way to explain market craziness without resorting to the assumption that people are a) crazy or b) do not have access to what is essentially public information. Under rational belief theory "the variability of economic magnitudes is determined, in part, by the variability of the exogenous variables but may be drastically affected by the variability, over time, in the states of belief of the agents." In other words, people change their minds and this affects economic outcomes, such as the direction of the stock market. These people are not irrational; they are simply making their best guesses given their limited understanding of how the world works. If enough people change their minds, this can have substantial impacts on the economy (and your portfolio).

Now here's the fun part: According to the theory of rational expectations, it is impossible to beat the stock market unless you have information not available to all. Such information is becoming increasingly hard to come by in this day of rapid communications (unless your name is Martha Stewart, in which case you would be wise not to act on this information). But according to rational belief theory, all that we need to beat the stock market are 1) for investors' beliefs to be correlated with some consistency over time, 2) to have some idea of how investors' beliefs are correlated, and 3) a belief in rational belief theory.

If investors' beliefs are correlated (that is, if people do not change their minds in a random way independent of what others are doing and thus there exist patterns to all the mind-changing), then these correlations will create patterns in the behavior of the stock market. (Human nature gives reason to believe that investors' beliefs are indeed correlated in a relatively stable way--fear breeds fear and greed breeds greed.) If investors' beliefs are correlated in similar ways over time, then these patterns will be recurring. If we are able to spot even a fragment of such a pattern, we can profit from this knowledge.

Index Rx is founded on the Dynamic Indexing and Monitored Relevant Indexes models, which are based upon pattern spotting. All we need is the conviction to act upon the knowledge of market patterns that these models provide. Of course, if we believe that markets are efficient, then our conviction will fail us. If, on the other hand, we believe in rational belief theory, then we have good reason to follow through. (And if Professor Kurz has been doing as well with his investments as our subscribers have with theirs, then perhaps his enthusiasm for rational belief theory is now a little more understandable.)