The pandemic has created uncertainty in every aspect of our lives, from the way we work to the way we care for our families. In the business realm, this uncertainty extends to supply chains, economies, and general investment practices — creating a financial world that is just as unpredictable as the physical world in which we currently live.
To help provide some clarity on the pandemic’s influence on the economy, last December the Marleau Signature Lecture Series on Economic and Monetary Policy hosted renowned financial economist and distinguished MIT Sloan School of Management Professor Andrew W. Lo.
In a lecture entitled “Financial Market Dynamics and Systemic Risk in a Post-COVID World”, Lo used his Adaptive Markets Hypothesis (AMH) to analyze current markets and suggest what stakeholders need to watch for in the coming months and years.
In this Q&A, Professor Lo answers a few questions from guest interviewer Mike Heffernan, Chief Technology Officer and Chief Software Architect at OpusEdge Inc.
This interview has been edited for brevity.
Mike Heffernan: Considering the Adaptive Market Hypothesis (AMH), in which you stress the need to adapt, I've certainly been feeling disoriented by the stock market’s apparent disconnection to the underlying economy. I need to recalibrate because anything that I've used for metrics in the past has gone out the window. Is there a metric that matters in the Fed’s balance sheet now? What is the recalibration required in today's environment?
Andrew Lo: The approach that I prefer is trying to understand why the traditional metrics aren't working and to figure out whether or not there’s a way to adjust them. It is conducive to being able to come up with insights that pass the smell test.
The bottom line is: how do businesses generate cash flows? Ultimately, that’s how you create value for investors, right? That process has changed because of what generates value for businesses, and therefore, investors. It’s become much more related to information provision and social interaction. If you think about the multi-billion-dollar businesses that have been created over the last decade, apart from the usual suspects like real estate and pharmaceuticals, the vast majority of the value that’s been created has been in the technology space, and it’s been created by way of information processing or information provision.
That, I think, is the key to understanding why these valuations look so crazy: it’s because we're not really valuing information in the way that that we ought to. If we think about altering the metrics to include some kind of information technology impact or value, the traditional methods of thinking about discounting cashflows will work again.
A good example is the typical Internet business that focuses on retail interactions. We know that market share is very important. Burning tremendous amounts of cash, in the case of this business, may seem crazy, but if you are able to establish a reasonably loyal base, that will generate profitability going forward manyfold. Additionally, the data that you collect from your client base can be used to reposition the business in a very profitable manner. If you include clickstreams and client data in your calculations, then your earnings and your price-to-earnings ratio start to look very different.
Mike Heffernan: Does AMH imply that we’re constantly fighting the last war? Always, to some degree, behind the environment?
Andrew Lo: I forget who said “Nature is red in tooth and claw” (Ed. Alfred, Lord Tennyson), but we're always fighting. We’re always bleeding and we’re always adapting, unless you get to a very rare situation where the predators and prey are exactly in the right balance, so that you live in a stable environment. In economics, we call this stationary processes. But equilibrium is a really unusual situation in nature. Either you’re growing or you’re dying. The Zen Buddhists have an even more succinct way of putting it: “To live is to suffer”. It’s a constant struggle — life is short and then you die.
Mike Heffernan: Maybe one way to measure empirically the AMH is to actually track the genome. You look at who the players are in the market, which “species” are succeeding or failing. As time goes by, you see newcomers emerge and others fall off.
Andrew Lo: If you take a look at the companies and sub-industries that have succeeded over the last seven months, and those that were hit hard, it really looks like an evolutionary winnowing.
COVID-19 may well be the kind of catastrophic event that ultimately wipes out some dinosaurs, metaphorically. It was the death of this species that gave rise to mammals.
When you focus on the evolution of these different business lines, it’s very much like the kind of dynamic that we’ve seen in other catastrophes.
Mike Heffernan: Did you have, as a result of the COVID-19 shock, new insights about how things transpired?
Andrew Lo: Virtually everything that I do now I do through the lens of adaptive markets. Once I realized that we’re not in equilibrium most of the time and that we are all competing for our own little niche, it really changed the way that I view everything, whether it’s investment strategies, risk management policies, or government policy and intervention.
All of us have had to adapt quickly to these changing economic conditions. In this context, AMH is a framework that is much more useful than the traditional rational expectations of a neoclassical economic framework. But at the same time, there is a lot more work to be done.
The efficient markets hypothesis and more generally, neoclassical economics, is not wrong, it’s just incomplete. By thinking about the economy as an ecosystem, we have a much better chance of developing more consistent theories that can explain phenomena like a pandemic or a recession or a financial crisis.
Mike Heffernan: In closing, if you had something to say to a general university readership about COVID-19, about financial markets, about the state we’re in, what would that be?
Andrew Lo: The pandemic is a very finite event. It will be over in a few months. But during that time there’s tremendous risk — financial risk, but more importantly, health risk to individuals as well as to the community.
I want students to remember that their actions have tremendous implications that go far beyond the next six-to-nine months. If we can stay safe and healthy, and can look forward to the time when we’re all vaccinated and can gather together without endangering lives, that’s something we ought to strive for. The dividends will last a lifetime if we can stay safe.
I think there is a lot to be optimistic about. I think that we’re going to see an unprecedented period of economic growth and prosperity over the course of the next five to seven years. So much so that I worry about the next financial crisis. In the meantime, it’s going to be a lot of fun getting there. There’s going to be a lot of partying, a lot of celebrating. I just hope someone will be wise enough to take the punch bowl away before the next reckoning.
Our next lecturer in the Marleau Series will be Dr. Emi Nakamura on April 30.
Dr. Nakamura is the Chancellor’s Professor of Economics at the University of California, Berkeley. She is an award winning and highly cited researcher in Inflation and Price Dispersion, Monetary and Fiscal Policy.
More details can be found on the Marleau series webpage.