Last Thursday, Facebook suffered the biggest one-day loss in the history of Wall Street.
The company’s shares dropped nearly 19 per cent.
Rather incredibly, Facebook reported an increase in revenue of no less than 42 per cent over the same quarter last year, and a rise in profits of 31 per cent.
But the narrative which swept the markets was wholly negative. Investors focused on the less-than-expected growth in new users, and on the company’s projection that its profit margins will fall in 2019 – from its current 44 per cent to just the mid-30s.
A wholly plausible alternative story would have been that the company continued to grow very strongly, but there would be some slow-down from the recent stratospheric rates of expansion. And the board was fully aware of the situation – this was not an adverse surprise.
The facts could have been used in support of either of these narratives. Yet one of them prevailed, and the other got no traction at all.
Objective evidence was perhaps a stronger element in the 20 per cent fall in the Twitter share price the day after the Facebook plunge. The company reported a drop of one million users following its action to delete fake and offensive accounts.
But even here, a different story could readily be concocted. A potentially major problem had arisen, but the company had taken decisive action to deal with it. Further, its efforts to monetise the platform were starting to work.
John Maynard Keynes emphasised the importance of narratives, rather than mere facts, in financial markets. He described what has subsequently become known as the Beauty Contest Game.
In the politically incorrect 1930s, newspapers would run competitions based on pictures of young women in bathing costumes. But the winner did not have to judge which of them was in some objective sense the most beautiful. Rather, they had to guess which one most entrants would select as the best.
Keynes pointed out that this can rapidly become even more complicated in the markets. As he put it so elegantly: “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”
Scientific advances in the twenty-first century are making it possible to anticipate which narrative around a particular event will predominate.
There are two separate aspects of this. The first relates to our understanding of how ideas or stories either spread or are contained across networks of individuals. It turns out that where a narrative gets its initial traction in the network can be much more important than its actual content.
The second of course is the development of artificial intelligence and big data. These technologies enable the networks which connect people, whether on Twitter or in financial markets, to be mapped in detail.
It is not just hedge funds but central banks such as the Bank of England that are interested in these exciting new technologies. There is power to be had in mapping alternative narratives and predicting the future.