Whether true or not, these stories - which circulate in office corridors, at the coffee machine, in schoolyards, at family dinners or at parties to glamorize society - have a crucial influence on the fate of the economy and the valuation of assets. Whether it's believing that crypto-currencies can only go up, that real estate is a risk-free investment, that some big banks are too big to fail, or that a stock has fallen so far that it can't go any lower, we all believe stories that are more or less true, more or less verified, but who cares : these stories, passed on by word of mouth, relayed by news media and increasingly on social networks, go viral because we like them. And despite the obvious weight they have in our decisions about where and when to invest, they are relegated to the background by investors who believe they have a more refined and rational perception of reality than the average doxa. No, we are all subject to emotional biases. Accepting and understanding them is the only way to learn to master them.

It is impressive how the study of popular stories that affect human behavior has the potential to improve our decision-making in the face of uncertainty, market panics, financial crises or any other major economic event in order to better seize the opportunities that come our way. We will try to understand how and why these stories have a significant impact on the economy, and in particular on financial markets and asset valuations, and how to deal with them to make better decisions as an investor.

The power of storytelling

Stories are an effective way to convey important information and values from one individual or community to another. Emotionally compelling and personal stories engage the brain more (including through the secretion of the feel-good hormone oxytocin), and are therefore better remembered, than simply stating a set of facts. The important thing is that it makes sense to us, that the story we are told resonates with our experience and our perception of the world. A story will always have more impact than a statistic.

Investors know what I'm talking about: the power of storytelling. It's amazing how compelling a well-crafted story can be. And that's something that brands and influencers understand. Take Tesla, for example. Elon Musk has created such a strong imagination around the Tesla brand without spending a single dollar in communication budget. It's the story of a little genius who founded Zip2 and then X.com a few years later (which will be renamed Paypal), before embarking on his life mission: saving humanity by preserving the planet (the object of Tesla and electric cars to face the "evil thermal vehicle manufacturers who pollute") or by finding a new home for humans (the object of SpaceX with the colonization of the planet Mars in sight). This story of preservation of the planet and the space dream gives us the impression of being part of something bigger than ourselves. All this collective imagination shared by many fans - whose stories resonate with them as full of good sense - has created a lot of buzz around Elon Musk's companies beyond the financial sphere. It raised a lot of capital, which was necessary for his project to succeed in a very capital-intensive industry, and drove Tesla's stock to new heights. Elon Musk succeeded in making Tesla the world's number one electric vehicle manufacturer thanks to his entrepreneurial genius but also because of his well-crafted storytelling. 

Stories have more impact than statistics

We'd like to think that investors use all the information available to them to make investment decisions and weigh the pros and cons based on the weight of each piece of data on the potential success of their investment. But the reality is that stories are more important than statistics in our decision-making process and, more importantly, they stay with us longer. Thomas Graeber's work at Harvard University has shown that a story that has as much influence as a statistic on a decision at a given moment will become more important in the decision-making process than the statistic as time goes by. If we add to this the confirmation bias (i.e. the tendency to look for information that confirms our way of thinking and to neglect anything that could challenge it), we have a real cocktail that negatively influences our decision making.

Not all stories are false. Some are true and some contain a core of truth sprinkled with exaggerations. Since humans are deeply emotional and irrational, these stories are reflected in the financial markets, which are simply the sum of the divergent and paradoxical opinions of humans (influenced by these stories) weighted by their capital.

If well-crafted stories do indeed modify our attitudes, beliefs and behaviors, they do not have the same influence depending on the time scale. While in the long run markets are rational and eventually follow the growth in earnings per share weighted by risk-free rates, in the short run, however, markets can overreact to an underlying news story or fear.

To think that markets are rational is to forget much of the history of the stock market. Let's not forget that Dutch people bought tulip bulbs for more than the price of their house, that speculators bought anything that ended in .com without looking at the valuations or that WallStreetBets fanboys pushed up meme stocks to burn hedge funds in short selling mode. The markets are more like a raging torrent with multiple and contrary currents that brew a logic more dreamlike than causal.

Narratives amplify reality and can create opportunities

The stories that work best use a reality but distort and amplify it, leading to exaggerated price movements - both up and down - and thus the appearance of market anomalies. These stories are based on current events and social phenomena such as the covid-19 pandemic and the generalized confinement (2020), the invasion of the Russian army and the beginning of the war.s invasion and the beginning of the war in Ukraine (2022), the risks of recession due to uncontrolled inflation and exploding financing rates (2022-2023), to name the most recent. Other narratives are less macro and more sectoral, such as the trendy sectors of cloud computing with the digitization of society, lithium with the scarcity of resources and the advent of electric vehicles, or hydrogen as a new way of mobility in the future. Other less fashionable sectors are suffering from the opposite effect, i.e. unpopularity: the oil, banking and automotive (ex-EV) sectors are the most affected (and this is reflected in their valuation relative to the rest of the market). While this premium or discount is largely justified and strongly linked to future growth prospects, it is often amplified by operators due to a lack of visibility on the future.

But most of the time, the market is right

The difficulty is to quantify this influence in terms of return on investment for investors. Should we take advantage of the crowd movements on trendy stocks? Or, on the contrary, be contrarian and buy what is falling unfairly?

To be honest, it depends. There are a lot of variables at play. On the one hand, when you enter a stock after stock-bashing on a particular stock or an entire sector, you can make a good deal because as Warren Buffett says: "price is what you pay, value is what you get". If you can buy a stock that is worth 2 dollars at the price of 1, you are getting a good deal! In theory, this is very true, but in practice, most seemingly unjustified drops turn out to be justified some time later.

Take the example of French retirement homes group Orpea, whose market capitalization has melted by 98% since its high at EUR 129 and by 96% since the publication of the book "The Gravediggers" on January 26, 2022, which reported many issues with the management of care homes. The stock had fallen by 42% the week before the book was published. After the sudden fall of the stock by several tens of percent in a few days, an investor focusing on the stock might have thought that mere rumors about the company's "reputation" could not justify such a drop. After all, Orpéa is all about assets and there is a floor linked to the value of its assets. This was without taking into account the weakness of the company's balance sheet, the restructuring of the company and the massive dilution of the shareholders that followed. It is as if the market knew as early as January 2022 that the company would collapse 6 months later.

Stories explain the stock price

Contrary to what was believed a few years ago, stories are of major importance in explaining stock prices. As Robert Shiller pointed out in his presidential address to the American Economic Association in 2017, which later became a book(Narratives Economics, 2019), these narratives can explain the market economy. Robert Shiller argues that to improve their understanding of the economy and financial markets, economists must look beyond typical economic indicators to incorporate the stories that affect individual and collective economic behavior. Only with recent technologies such as AI and textual analysis (natural language processing) can we harness these stories in a systematic way to measure the impact on stock prices. For example, Pukthuanthong's (2021) work has processed nearly 7 million New York Times stories over the past 150 years. This researcher showed that analysis of panic stories in the pages of the New York Times is highly relevant to predicting future U.S. stock market returns. The work of Calomiris and Mamaysky (2019), Engle et al. (2020) or Blanqué et al. (2022) come to the same conclusions: stories have a major importance on stock prices and greatly influence the market economy.

The momentum effect linked to stock popularity

To study the impact of these stories on stocks, Chinese researchers have analyzed the concept of "thematic stocks", grouping them according to the nature of their activity rather than by sector. For example, some technology stocks are related to the theme of artificial intelligence while others are more related to cybersecurity. However, in this example, they are all part of the technology sector. But a more detailed analysis of the themes allows us to measure the impact of the stories in a more relevant way. For example, in this Chinese study, trading apps in the Middle Kingdom group these actions together and allow the researchers to analyze the trends in the narratives. What they found was that a momentum effect associated with market narratives causes investors to bet on popular stocks and sell those whose interest is waning. Stocks associated with a popular story benefit from this popularity and suffer a decline when popularity declines. The chart below shows the performance of a strategy based on stocks linked to stories that gain or lose popularity, as well as a long-short strategy to buy what gains in popularity and sell short what declines in popularity. The outperformance is impressive for the long-short strategy, reaching 15% per year between mid-2014 and the end of 2021, well ahead of the Chinese indices.

Performance of the China thematic equity investment strategy:

Source: Du et al. (2022) in Klement Investing

While the application of this method to the Chinese market, whose dynamics differ from developed markets, can be criticized, the momentum generated by these narratives seems exploitable. It seems that there is a kind of momentum linked to fashionable stocks. However, one has to be aware of the risk involved and be nimble to get out at the right time when the popularity inexorably declines at some point. In practice, all this seems very difficult but let's see if there are trends.

Stories influence the market unevenly

Researcher Chukwuma Dim found similar things when he measured the beta of stock prices against the market narratives of all U.S. stocks.He found that stocks with higher "narrative beta" experienced increased "noise" around their stock price, higher trading volume and less informativeness of the stock price relative to future fundamentals. In other words, stocks with high exposure to a market narrative (both positive and negative) begin to move further and further away from fundamentals and become more volatile.

What's also interesting about their study is that they show which parts of the U.S. market have higher exposure to market narratives and how that affects the valuation of those stocks. The chart on the left reveals that the larger the size of the company, the more likely it is to be exposed to these narratives and the higher its narrative beta. This makes some sense when you think about it. Most narrative investors will focus on the largest companies to play a theme (Nvidia for semiconductors, Tesla for electric vehicles, etc). But if we combine this observation with the fact that stocks subject to narratives become disengaged from their fundamentals, it means that smaller stocks are on average much more driven by fundamentals. In other words, fundamental analysis is much more likely to be a useful exercise for small stocks than for large stocks.

Then, in the chart to the right, we notice that pharmaceutical and commodity companies have higher exposure to the dominant market narrative. This is also not surprising, given that much of the narrative of the past decade has been dominated by the rise of China, the energy transition and resource scarcity on the one hand, and the advent of novel medical treatments and the covid-19 pandemic on the other.

Narrative beta by size (left) and by sector (right):

Source: Dim et al. (2023) in Klement Investing

In their study, the authors examined not only positive narratives, but also negative narratives. And it seems that negative stories have a stronger impact than positive ones. Indeed, for example, the narrative about the end of oil due to the energy transition and the shift to renewables drove oil company prices very low to a bottom that was not thought to be reached. The authors find that this negative effect is larger than the surge in positive narratives, essentially reflecting investor loss aversion. These negative narratives thus depress stock prices well below the valuation justified by fundamentals. Not only can these narratives depress stock prices for a long time, but once the narrative changes as with the reversal in oil prices in 2020 and then the acceleration with the start of the war in Ukraine in 2022, the performance can be explosive and last much longer than many investors might expect.

Key takeaways:

  • Stories have a stronger and more lasting impact on our perception of reality and our decision-making than statistics.
  • Stories can explain a large portion of stock market fluctuations and their analysis can be used to improve forecasts of future stock market returns.
  • The stories that work best use reality but distort and amplify it, leading to exaggerated price movements - both up and down - and thus the appearance of market anomalies.
  • Knowing how the underlying narratives of a market, a theme or a company, both positive and negative, are articulated is therefore essential for positioning a portfolio, especially for large caps and the pharmaceutical and commodity sectors.
  • Stocks with a high exposure to a market narrative (both positive and negative) are more volatile and their valuation is more likely to deviate from their fundamentals.
  • There is a momentum effect related to a stock's gain or loss in popularity.
  • While negative stories may exaggerate the price of stocks exposed to them and sometimes create investment opportunities, each case must be analyzed independently. Be wary of what you think you know about a company; not all information may be in the public domain. And most of the time, the market is right to lose interest in a stock.

The illustrations were generated with the Midjourney tool