Markets and the Crisis of Knowledge

The New Yorker has an interesting article today on why the current financial market is similar to postmodern literature criticism. Short answer: market value (especially "mark-to-market" valuation) is as elusive as meaning in deconstructionism.

Aha! We all knew this was really a crisis of epistemology, didn't we? How do we know what we know? How can you determine value when it is merely what the market determines it is at any given time? This is not "objective value," but rather perceived value.

But lo! There's no difference! Value is always perceived.

There exists no objective value of gold. Yes, it has historically been prized by some cultures for its luster and malleability. But mostly, its value has been high because of its status (socially-constructed) as a luxury metal. The price of gold has risen and fallen not according to some price equilibrium reflecting its underlying objective value. Supply and demand curves can explain the current price, but even the economic law of supply and demand equilibrium leaves out a glaring unexplained factor. Why is gold demanded at a certain level at a certain time? What sets the demand curve?

And, since the demand and supply curves are reflexive, in that a change in one changes the other, even the supply is dependent upon the mysterious origin of demand. There is a certain amount of gold in the ground. Only the gold that people take the trouble to dig up will enter the marketplace as supply. The gold producers will only dig up this gold if the market price they can expect will make that enterprise profitable. If the price is high, they will dig deeper and deeper, willing to spend more and more on extraction of ever-more-elusive deposits. Since the gold ingots sitting in veins of exposed rocks are much cheaper to collect than gold buried miles under the ground, there are diminishing returns to scale in a given source. How deep the producer goes hits its limit when it costs more to extract that last marginal unit of gold than the gold will sell for back on the surface.

The same principle applies to oil. We'll "run out" of oil long before the actual petroleum deposits are exhausted. The deepest, dirtiest, hardest-to-get-at oil will sit down in its geological tank because it is economically unextractable. To do so wouldn't be worth the trouble, since you'd loose money. On the other hand, what are considered economically-extractable reserves expand with the market price of oil. Nobody considered the billions of barrels-worth of oil in the tar sands of Alberta until oil prices started approaching triple digits.

In short, though the interaction of supply and demand does predictably give rise to price, the whole dynamic cannot be considered scientific (or objective), since subjective demand is the root of supply, price, and market value.

This is the realm of psychology. The consumer demands gold (rather than silver, platinum, titanium, or stainless steel) for subjective reasons of perceived value. This perception of consumer utility is affected by economic conditions, personal taste, trends, Divine Influence, solar flare activity, and TMZ.com. Furthermore, the dynamic of a trend presupposes that the perceptions of other consumers have a compounding effect for the perceived value among all consumers. As more and more consumers desire the new "hot" good, their collective perception of increasing value creates a positive feedback loop, with the perceived values of individual consumers and the market value (derived from all consumers) expanding co-currently.

Even more removed from a hypothetical underlying value of gold is the precious metals investor. The gold he buys and sells he likely never sees, nor uses for his own consumption. The consumer utility derived from a certain quantity of the metal does not concern him directly. To him, the certificate of ownership of the gold is merely itself a tradeable commodity. The value of his ownership of the share of gold is twice-removed from the gold itself. And, too, like the consumer who fosters his own perceived value of gold, the gold investor perceives that the gold share has a certain value--which is socially-constructed. He is betting that other people think or will think that gold share is worth more than he does. In other words, he is exercising his theory of mind.

Again, we see that the behavior of an individual is related reflexively to the behavior of the market (being merely the sum of a group of individuals). By buying a share of gold, the investor himself has increased the value of that share. His perception of the value of that share--and his willingness to act on that perception--has in turn increased the market value of that share. If on balance, the other investors engaged in the market have the same perception of value of a gold share, they too will buy in. At the aggregate, their collective behavior shifts the stock price upward (if the net volume of trading is in a buy direction).

That last parenthetical is important, since one or a few participants (a hedge fund, for example) can drive the stock price up (or down) by merely buying a very high volume of the stock (or conversely, by betting against it by shorting it). Even if the minority of traders perceive that the shares are worth less, the sheer weight of high-volume purchasing can drive the market value upward. And with that, the smaller investors can respond to the gravity of the handful of high-volume investors by upgrading their perception of the stock's value. Like planets around a massive star, they are drawn into the orbit of trading behavior. This was seen in full effect when the infamous David Einhorn of Greenlight Capital publicly shorted Lehman Brothers, hastening that troubled investment banks demise (and arguably precipitating the entire financial crisis of late).

But wait, we can take this further... Merely the expectation that there will be a high volume of buying can be enough to convince traders to buy. Say, for example, Fast Money shouts to its audience one day that gold is a "must-buy." Odds are, the market price of gold will shoot up, as viewers rush to buy gold as low as possible before all the other people want to buy. At the tail end, some unlucky sap will be the last to the feeding frenzy, buying gold at a high higher than other people are willing to pay. This will then be the peak, when the market value of gold shares reaches its peak. People will stop buying, because they know that nobody else will be willing to pay more than the peak price (thus, they wont be able to sell profitably). The perception of value drops among individual traders, and so then does the market price. Fast Money goes on the next day saying gold is a "sell" now, and that silver has the best capacity for growth. And the process continues ad infinitum.

This is why market value is so volatile. Market value is reflexive and self-referential.
Market value is the aggregated future expected value of the current perceived value among investors of the future expected value of a firm or industry derived from the future expected value of all consumers toward its goods or services, determined in turn by individual consumers from the current perceived value among other consumers, which is determined by those other consumers from the future expected value among other consumers, etc. Any questions?

Moral of the story: Every market entrant acts according to perceived values, which are socially-constructed. Their actions arising from their perceptions cannot be decoupled from the effects of their actions, which cannot be decoupled from their perceptions of those effects and subsequent actions. Perceptions and realities are inextricably-intertwined and reflexive. This leads to a crisis of understanding among market participants, since observing and acting upon those observations shifts the observed market, rendering the original observation obsolete. Even the shared observations of non-market participants affect the market. Thus, there cannot be any objective observation of the market. There cannot be any knowledge about the market. Market participants are mired in an epistemological Catch-22. The blind leading the blind...