Is It the Market Going Crazy? Or Is It Traders?

Investors looking for why the stock market is in turmoil might want to go back to 1987, when "Walk Like an Egyptian" topped the charts and Janet Yellen, now the Federal Reserve chairwoman but then an unknown, untenured economics professor at the University of California, Berkeley, published a paper on the role of irrational behavior in market movements.

Titled "Rational Models of Irrational Behavior" and co-written with Yellen's economist-husband George Akerlof, then a colleague at Berkeley, the paper appeared just five months before Black Monday, the largest stock market crash in history, in which the Dow lost nearly a quarter of its value on a single October day.

Yellen's paper espoused a controversial approach that she appears to have increasingly embraced over the years: that markets are not orderly, rational machines of predictable, efficient behavior based on clear information, but are suffused with panic, greed and other irrational forces that drive human psychology, emotion and behavior.

"Economists have accorded the assumption of rational, self-interested behavior unwarranted ritual purity, while alternative assumptions—that agents follow rules of thumb, that psychological or sociological considerations matter, or that, heaven forbid, they act downright irrationally at times—have been accorded corresponding ritual impurity," Yellen and Akerlof wrote in the paper. "If agents really behave according to impure assumptions, is it not likely that the best models to fulfill that agenda will mirror that behavior?"

Wall Street investors are blaming the recent global stock-market turmoil on everything from fears of recession in Europe, to a slowdown in economic growth in China, to a collapse in world oil prices, to a potential end to the Fed's efforts to pump massive amounts of dollars into the U.S. economy—just as the American economy finally appears to be returning to some form of low-growth normality after the 2008 mortgage meltdown and subsequent crippling credit crisis.

Confused by the mixed signals the market is sending, investors are wondering whether the recent sell-off reflects the end of an irrational, speculative bubble in stocks—and whether the Fed will attempt to rein things in before that bubble bursts.

At a Boston Fed conference on Friday morning, Yellen gave few clues to her future actions, making scant comments on monetary policy and focusing instead on whether income inequality was "compatible with the values rooted in our nation's history."

But Wall Street might want to consider what appears to be Yellen's broad view of the validity of behavioral economics and behavioral finance to be found in her 1987 paper on the irrationality of market movements. In a little-noticed shift inside the Federal Reserve, Yellen appears to have increasingly embraced the tenets of her Berkeley thesis.

"Janet Yellen recognizes some behavioral phenomena, as do some of the Fed staff economists," Hersh Shefrin, a behavioral finance professor at Santa Clara University's business school," tells Newsweek. A former senior Fed official who declined to be named tells Newsweek that Michael Lewis's book Flash Boys: A Wall Street Revolt, about the disastrous things that happen when overconfidence (a focal point of some behavioral economic theories) and technology (high-frequency trading) collide, is "widely respected inside the Fed."

And Yellen's husband, Akerlof, a 2001 Nobel winner in economics who will join the faculty at Georgetown University next month, has in recent years co-chaired the National Bureau of Economic Research's behavioral economics group. "That leads me to believe that she absorbed some of the behavioral perspectives through the channel," says a leading university economist who also declined to be named.

By mid-morning Friday, the Dow had halted its six-day losing streak to regain some of its losses, as some large companies, including General Electric and Morgan Stanley, reported solid earnings and strategists speculated that Yellen's Fed might continue pumping money into the economy through quantitative easing, rather than tapering it later this month as previously expected.

Remarks on Thursday by the St. Louis Federal Reserve branch president, James Bullard, to Bloomberg that the Fed might prolong pumping money through bond buying continued to excite investors on Friday, particularly as the Standard & Poor's 500 index is still down more than six percent since its highs last September.

Infused by quantitative and qualitative work in psychology and sociology, behavioral economics stands in stark contrast to the efficient market hypothesis, a bedrock of modern financial theory since its genesis in the 1960s that holds that stock prices and stock markets as a whole rationally incorporate all relevant information an investor needs, making them largely predictable.

Evidence that Yellen still hews to at least some elements of behavioral economics, a form of Keynesian economics, appears in other recent papers and remarks by her.

While her predecessors at the Fed, Ben Bernanke and Alan Greenspan, steered clear of public comments on the work of Hyman Minsky, a behavioral economist whose ideas that markets are inherently unstable and prone to speculation as they expand are experiencing fresh scholarly interest, Yellen has not.

In April 2009, as the stock market and the U.S. economy continued to reel in the wake of the mortgage meltdown a year earlier, and the Fed, led at the time by Bernanke, arranged a massive bailout of Wall Street banks, Yellen, at the time head of the San Francisco branch of the Federal Reserve, told an academic conference in New York that "with the financial world in turmoil, Minsky's work has become required reading." Referring to what is known as the "Minsky moment," in which speculative bubbles burst and markets collapse, she added, according to a transcript, that "one of the critical features of Minsky's world view is that borrowers, lenders, and regulators are lulled into complacency as asset prices rise."

She posed a hypothetical question. "Should central banks attempt to deflate asset price bubbles before they get big enough to cause big problems? Until recently, most central bankers would have said no," she said, adding that "I myself have supported this approach in the past. However, now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look" at that approach.

Not that behavioral economics has all the answers. "I was as surprised at the low historic volatility before the recent turmoil as I am by the sudden spike in risk. Behavioral finance does not yet have a good framework for changing market volatility," says William Goetzmann, a finance professor and behavioral economist at Yale University's School of Management.

Asked about the gyrations, Richard Thaler, a behavioral economist at the University of Chicago Booth School of Business, referred to Keynes' dictum that "day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market."

Dan Ariely, a behavioral economist at Duke University whose research incorporates cognitive neuroscience, adds: "The only sensible thing is to talk about herding behavior and mood effects. When the market drops so much, it's very easy to be depressed and to act on that in multiple ways."

Citing the spread of Ebola and "the time of the year when days in the Northern Hemisphere are growing shorter—the documented seasonal affective disorder SAD-effect on equity markets," Hersh tells Newsweek that "negative mood catalysts such as fear of epidemics and declining hours of sunlight amplify the dynamic. We're seeing a lot of things coming together now."