2 - Unpredictably Unstable

Summary

Chapter 2 is about time-varying relationships driving stock price fluctuations and volatility and how novel events and narrative dynamics may be at play. It provides a survey of the relevant literature on structural change, popular forms, such as regime switching and parameter nonconstancy, and the potential sources of narrative dynamics related to instability. Emphasis is placed on whether transition probabilities are better understood as time-varying and how rare events fit in. Historic events that are good candidates for having catalyzed periods of change between stock prices and fundamentals over the last three decades will be identified. Narrative anecdotes from financial news will be provided in support of the view that much of the instability in the stock market is unforeseeable ex ante. Therefore, probabilistic, and other quantitative rules modeling change in stock market relationships are inappropriate when Knightian uncertainty events are unfolding in real time. Finally, the role of investor sentiment underpinning instability will be discussed through the lens of dictionary-based notions of individual rationality.