|This essay by Robert R. Prechter, Jr. originally appeared in The Elliott Wave Theorist on June 1 2002. It was reprinted in:
Prechter, Robert R. (2003). Pioneering Studies in Socionomics. Gainesville, Georgia: New Classics Library, pp. 198-214 (Note: The book is also available for purchase as part of a two-volume set.)
The Enron Scandal: A Case in Point
The Socionomic Insight
The socionomic insight is that the conventional assumption about the direction of causality between social mood and social action is not only incorrect but the opposite of what actually occurs. Socionomics is based on a principle developed by deduction from the existence of the Wave Principle and by induction from the chronology of market behavior and other social actions. The principle is that social mood determines the character of social events.
As previous studies demonstrate, rising stock trends do not improve the public mood; an improving social mood makes stock prices rise. Economics do not underlie social mood; social mood underlies economics. Stock trends do not follow corporate earnings; corporate earnings follow stock trends. Politics do not affect social mood; social mood affects politics. Demographics do not determine stock market trends; the social mood that determines stock market trends determines demographics. Styles of popular art and entertainment do not affect the social mood; the social mood determines the popularity of various styles of art and entertainment. War does not impact stock market trends; the mood that governs stock market trends determines the propensity for war. And so on. All economic, political and cultural developments are shaped and guided by the Wave Principle of human social behavior. It is the engine of everything from popular fads and fashions to the events of collective action that make history.
Conventional belief is the opposite of the above insight. It is solidly entrenched and pervasive almost to the point of ubiquity. It is deeply intuitive and utterly wrong.
The conventional mind sees social events as causes of social mood. Few ever ask the causes of the events themselves. Those who do simply assign the causes to other events.
The Counter-Intuity of the Socionomic Insight
I continually marvel at how counter-intuitive the socionomic insight is. For the entire time of my professional career, I have been comfortable with the central implication of technical analysis, which is the primacy of market form over extramarket events such as economics and politics. (I eventually discovered to my dismay that technicians rarely accept this implication and believe that various random, unpredictable “fundamentals” are behind the market’s patterns, which is a contradiction.) Yet even I find myself upon occasion having to work hard at dispelling old contradictory thought patterns in order to re-establish mental integrity on the more difficult challenges of the socionomic insight. My first real challenge came from the claim that “demographics” determined stock price trends. I knew the claim had to be incorrect, and it took only a few days of research to debunk it. But it was only during the course of that pursuit that I began to formulate the proper response: that if indeed there were any correlation at all, the causality had to be in the other direction. The result was the 1999 study, Stocks and Sex, which shows exactly that. My latest – and greatest – challenge to date has been the proper conception of the Federal Reserve Bank’s role in the causality of monetary trends, which I will discuss in an upcoming report. [See “A Socionomic View of Central Bank Causality” – Ed.]
The average person’s resistance to the socionomic insight is so formidable that it compares to having one’s view of existence challenged. I believe that the reason for this resistance is the easy naturalness of the idea of event causality: It works in physics, so people assume that it must operate in sociology. This deeply rooted assumption is stronger than piles of evidence to the contrary.
Let me give you an example of how strong this resistance is. On April 25, 2002, I was pleased to address the Sixth Congress of the Psychology of Investing, sponsored by the Massachusetts Mental Health Center, which is a major teaching hospital of Harvard Medical School. Attendance ran the gamut from academics and psychiatrists to Wall Street professionals and private investors. After presenting the Wave Principle and explaining its social effects, I was told by numerous attendees that the presentation had changed their perspective on markets and social causality.
The following day, I attended the afternoon’s final half hour, in which attendees were given the opportunity to ask questions of that day’s panel. The final question was, “The Enron scandal has deeply discouraged investors; when can we hope that this black cloud hanging over the stock market will go away?”
Several respondents – both from the panel and the audience – answered the question as if it were valid. Not a soul in the room challenged the questioner’s assumption.
A week later, USA Today and doubtless countless other newspapers and magazines were trumpeting the same theme. “Scandals Shred Investors’ Faith,” declared a front-page headline. Begins the article, “A drumbeat of corporate misdeeds has helped crush stock prices and eviscerate pension plans.”1
If you recognize the socionomic insight as a principle, you need know nothing about the details of the situation. You can formulate the proper response immediately. Before reading further, would you like to give it a try? Remember, the socionomic insight is that the conventional assumption about the direction of social mood vs. event causality is the opposite of what actually occurs. I will make your task easy by re-stating the assumption that the questioner held: “The Enron scandal discouraged investors.” Can you state its opposite in terms of causality?
The Significance of the Enron Scandal
Did the Enron scandal discourage investors? No, discouraged investors precipitated the Enron scandal.
Many readers undoubtedly will balk at accepting the principle behind this formulation without their own tedious process of induction via repeated examples. To aid in that process once again, we must disprove the questioner’s and media’s false premise and demonstrate the validity of the socionomic stance.
First, let us define scandal not as misdeeds themselves, which can occur in secret. Scandal is the recognition of misdeeds, the outcry of recrimination and the public display of interest and outrage.
The premise is revealed as utterly false when we observe, despite virtually everyone’s feelings to the contrary, that (1) investors in general knew nothing about Enron’s malpractice prior to or anytime during the stock market’s decline, and (2) throughout the drama of the Enron scandal, the market advanced, and related psychological indicators improved. Figure 1 shows the stock market’s progress, two measures of optimism and the key events surrounding the Enron scandal.
It is abundantly clear that as the Enron scandal developed,investor and consumer psychology improved, and stock prices rose.Therefore, it is utterly false that the Enron scandal “discouraged investors.”
Anyone who posits event causality in this instance is boxed into a corner. Given the facts before our eyes, he has no choice but to conclude that the Enron scandal was bullish for stock prices and that it caused investors’ mood to improve!2
I would like to proceed directly to what would seem to be an obvious statement: that such a conclusion is ridiculous. Incredibly, though, I cannot say it. Why? Because conventional analysts actually proceed directly to such absurd conclusions repeatedly as a matter of course.For example, The Wave Principle of Human Social Behavior relates a news report of an analyst who watched the stock market rally despite revelations of President Clinton’s misbehavior and came to the conclusion that presidential sex scandals are bullish! Economists have reviewed the temporal proximity of war and economic recovery, and they assert, almost to a man, that war is good for the economy. If economists can argue that the most destructive activity of man is a positive force for economic well being, then conventional thinkers will have no trouble devising an argument as to why financial scandals are bullish. I can do it myself; such rationalization is easy.
The only antidote to such perversity is the socionomic insight. War is not causal to any aspect of social mood; it is a result of a deeply negative social mood. Likewise, the Enron scandal was not causal to any aspect of social mood whatsoever; it was a result of a change in social mood.3
Figure 2 demonstrates the chronology that supports this statement. As you can see, the stock market fell for many months prior to the scandal breaking. This meter of social mood showed increasing negativity – involving conservatism, suspicion, fear, anger and defensiveness – all of which went into precipitating the Enron scandal. As the CEO later explained, increasing conservatism affected the company’s derivative positions, bear markets triggered “exit clauses” that allowed partners to their deals to withdraw their funds, and increasing fear and suspicion prompted them to do it. Throughout 2001, the company’s stock retreated, removing support for financing. The house of cards built upon confidence collapsed.
By the time the results of that negative mood trend brought the Enron scandal to light, the negative mood trend was already over. The S&P 500 completed five waves down on September 21, and it was time for the largest rally since the high in March 2000 (as forecast in The Elliott Wave Theorist on September 11).
During that rally, these particular consequences of the downward mood trend became manifest.4
Now we know for sure: The Enron scandal did not “discourage investors” or “shred investors’ faith”one bit. Their level of faith rose during the scandal. It did not “crush stock prices and eviscerate pension plans,” either. Stock prices rose during the scandal. All the hand wringing and ink spilling on this presumption has been a waste of time and energy.
To make a subtler point, “corporate misdeeds” are not even to blame for the bear market that preceded the eruption of the Enron scandal. Corporate misdeeds were in full flower throughout the 1990s, yet no scandals erupted. In fact, those very misdeeds – Ponzi-like accounting practices – could be credited with raising stock prices and fattening pension plans during the 1990s to the same extent that they could be blamed for crushing and eviscerating them now.
Yet the proper amount of credit to assign to suspect accounting practices for both trends in stock prices is zero. The credit goes to a change in mass psychology. Various accounting irregularities were an effect of the psychological environment. They were in place for years, and they were reported from time to time, sometimes in major journals, but during the bull market, few cared. Corporate misbehavior persisted for a decade, but there was no scandal until well after the trend changed. While the trend was up, people ignored the phony accounting; when the trend turned down, they began to investigate it. When the trend was up, psychology supported both actual and illusory corporate health; when the trend turned down, psychology caused both actual and illusory corporate health to deteriorate rapidly. Again, the formulation of causality is the opposite of the conventional belief: Corporate misdeeds did not crush stock prices; crushed stock prices finally drew back the curtain on corporate misdeeds. What, then, caused corporate misdeeds to expand so greatly in the first place? The mass psychology of the stock mania, which was unskeptical to an extreme, invited and even rewarded companies for “creative accounting.” It was the psychological environment of the bull market that led companies to dare to mislead investors in the first place.
The Power of Socionomic Prediction
Figure 2 at least sets the chronology of the true cause and effect with respect to the Enron scandal. It falls short of proving it, of course, as the other option regarding causality is that the two events (and all the others we have explored) are unrelated. Let’s see if we can dismiss that hypothesis.
An important aspect of science is the ability of a hypothesis to predict. Using the socionomic insight, could anyone have predicted the flood of accounting and corporate scandals that has so far climaxed with the revelations regarding Enron?
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Most economists, historians and sociologists
presume that events determine society’s mood. But socionomics hypothesizes
the opposite: that social mood regulates the character of social events. The
events of history—such as investment booms and busts, political events,
macroeconomic trends and even peace and war—are the products of a naturally
occurring pattern of social-mood fluctuation. Such events, therefore, are not
randomly distributed, as is commonly believed, but are in fact probabilistically
predictable. Socionomics also posits that the stock market is the best available
meter of a society’s aggregate mood, that news is irrelevant to social
mood, and that financial and economic decision-making are fundamentally different
in that financial decisions are motivated by the herding impulse while economic
choices are guided by supply and demand. For more information about socionomic
theory, see (1) the text, The
Wave Principle of Human Social Behavior © 1999, by Robert Prechter;
(2) the introductory documentary History's
Hidden Engine; (3) the video Toward
a New Science of Social Prediction, Prechter’s 2004 speech before
the London School of Economics in which he presents evidence to support his
socionomic hypothesis; and (4) the Socionomics Institute’s website, www.socionomics.net.
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