The first time I remember having experienced any crisis related to the global economy was during the global oil crisis in the 1970s, when I was five years old. It felt like magic: The adults were completely absorbed with worrying about abstract things like their professional futures or how to pay the rent for the next month. Nobody had time to bother about supervising children, and the everyday displeasures of a five-year-old, such as having to eat up one’s vegetables, were dwarfed by the bigger geopolitical landscape and its risks to payrolls.

Then came the Sundays: the highways were empty, because the sheiks made our governments shut down traffic one Sunday per month, so we had vast areas of concrete just for us, our bicycles and our roller skates. On a normal workday, we would not have lasted more than two seconds between the roaring lorries! It felt as though a wild childhood dream had come true – only comparable to being locked up in a candy shop or staying overnight in a toyshop.

The mundaneness of a pandemic
Those wild childhood dreams probably made wise men see crises as an opportunity later in life. Yet when we look at the pandemic that has hit the world in 2020, I struggle to see the attraction I saw in the oil breakdown. This may only be partially related to the fact that I have joined the boring worrying class of grown-ups in the meantime. I wonder whether my children will have such warm memories of the pandemic as I have of the oil crisis.

A seven-year-old child who was stuck in quarantine with all the other travellers on a cruise ship this January was quoted as saying: “This is the best time of my life,” before being incredibly worn out after seven days of Netflixing and computer-gaming, according to his mother. In my view, the recent crisis will rather be remembered for the disappearance of toilet paper in supermarkets.

Can it get more mundane? From an economist’s point of view, there is an interesting dissonance between what authorities communicated and expected to occur with regard to the shortage and what actually happened. They said, “It is highly irrational to hoard toilet paper now” to discourage people from hoarding toilet paper, but instead it created a stampede of people chasing all toilet-paper stock available in retail shops. It is like a police car in your street asking you not to panic via its megaphone. Then you know something worrying is brewing. So ‘irrational’ resonated with me, as it was accurate in one sense but completely inaccurate in another sense.

The poster child of a systemic breakdown
In the media coverage about this topic, it really struck me how psychologists were struggling to explain the fixation on such an ordinary item as toilet paper in times of a health crisis. Some psychologists were quoted as saying that this was about protection. Others went into more daring Freudian concepts that I will spare you from here – just to keep our sanity. For an economist like myself, the explanation is much more banal and simple: the scarcity of toilet paper is the poster child of a breakdown of supply in an economic system. If daily supplies such as toilet paper become unavailable, it is a sign that the economy is close to a collapse. This was the recent experience in Venezuela, where we saw the exact same television footage (well ahead of the global pandemic). So hoarding toilet paper is a rather inexpensive (and maybe also ineffective) option to prepare for an economic collapse.

Rational versus irrational behaviour
So rationality, as defined by the authorities, means not hoarding toilet paper, as there is enough stock to supply regular demand. That is rational indeed when thinking in ‘ceteris paribus’ terms, which is a fancy way in which scientists say, “all other things being equal”.

The problem with this term is that hardly anything else is equal in times of crisis. So in theory, the stock is more than big enough to meet the ongoing demand – just not when demand jumps by a factor of two or three, as it does when people start hoarding. Crises thus reveal the power of a narrative in human society. The crisis narrative is quite simple: “A pandemic means a breakdown in economic supply. A breakdown means that the supply of everyday items eventually becomes scarce. Toilet paper is a basic item, so go chase it!”

The narrative was reiterated, of course, in the television footage of Hong Kong after the outbreak. People seemed to be fighting over supply, and burglars were targeting bulks of hygienic paper in a heist (not that we could ever verify whether the reports were accurate – who cares when animal spirits rule). To the average viewer it was clear: case confirmed. That is the exact tipping point where rational strategies (in this case, ‘buy as you go’) fail compared to irrational strategies (i.e. ‘hoard as much as you can’). We ran some empirical studies recently within my family, and it took us about ten days after the hoarding wave until we spotted the first pallet with toilet paper in a regular shop. We bought it all, of course. Just kidding. But you get the point. In this case, it would have been rather rational to follow the irrational strategy in the first place.

Game theory: The prisoner’s dilemma
Laypeople love it when experts miss the point, but let us not get carried away. First of all, authorities had other priorities to deal with than the lack of hygienic paper. And secondly, the phenomenon of irrational behaviour in stressful situations is widely acknowledged in social sciences. For instance, game-theory scientists (i.e. those who look at social interaction as if it were a game) were early in commenting on the topic. One of their first contributions was about the ‘prisoner’s dilemma’.

This is a situation where two imaginary prisoners are interrogated separately. The game is set in such a way that it is more rewarding to admit a crime if the other prisoner denies it and even more rewarding if both prisoners deny it. The sad truth here is that both players in the game have a strong incentive to choose a strategy that leaves them with a less rewarding result – by not colluding. The hoarding example has quite some similarities to the prisoner’s dilemma, as the overall rational strategy of ‘not hoarding’, and thereby colluding, would leave both better off (i.e. no scarcity in toilet paper) than any other outcome. Still, they tend to choose the other, overall irrational outcome, which looks perfectly logical from their individual perspective.

Financial markets: voting versus weighing machines
This brings us to financial markets. Stock markets are well known as places where rationality sometimes takes a back seat, but most often in times of crises. That is surely when animal spirits take over. But even in normal times, the question in the shorter term is not necessarily “which stock or bond is attractive?” but rather “which stock or bond is deemed attractive by the average investor?” Why? Because this defines which stock and bond will get the most inflows and see its price advance in the medium term. As Benjamin Graham once said: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Here again – whether assuming rational or irrational behaviour by others – it is not necessarily about judging the reality out there, but rather what others have as a perception of reality, whether this perception is right or wrong.

Momentum beats all - in the medium term
This is also mirrored by the performance of investment strategies. Many investors whom I have met in my professional life have aspired to be contrarian (i.e. to go against the herd of investors) and yet make money in the medium term, say 3–12 months down the road. Unfortunately, empirical evidence tells us that the two goals are hard to reconcile, if not mutually exclusive.

In fact, there is quite well-established academic evidence that momentum strategies (i.e. following the herd by buying assets that have done the best in the past months and selling assets that have done badly in the recent past) prevail in the medium term. This means that ‘following the herd’ is a superior strategy for typical investors who have a medium-term investment horizon. In the pandemic example, this means that hoarding toilet paper can continue for quite a while indeed.

It feels lonely to be a contrarian
In contrast, the contrarian strategy – i.e. betting against the herd – does not do particularly well on average. This does not mean that contrarian investing does not have its merits – quite the opposite. The trouble is simply that empirical evidence shows that it does best either in the very short term or in the very long term – just not in the medium term, where most investors try to apply it. This may be not as counter-intuitive as it seems. With regard to the short term, being contrarian can help you to benefit from short-term excesses and enjoy the reversals. So if everybody panics, you can benefit from a short-term reversal of the panic as the selling pressure eventually abates. Yet the negative trend more often than not resumes and proves harmful to contrarians. For the long term (i.e. at least 12 months, but preferably three to five years), there is quite some evidence that going against the dominant narrative can be quite rewarding.

To illustrate the point about the short-term and long-term benefits of contrarian investing, we can take a real-life example: European financials. These assets have underperformed almost all other assets over the past years. So momentum investors (and the herd) have always been short European financials, but that has not kept contrarians from making big gains in the space once in a while, as sharp rebounds have happened after short-term negative excesses. (So contrarian strategies have worked in the short term.) The jury is still out whether there is a long-term case for European financials, but if there is one, it will most likely take quarters, if not years, to materialise, rather than months or weeks.

What keeps us from becoming irrational altogether?
After these considerations, the question is, of course, how to decide when to switch from irrational to rational behaviour or from following the herd to being contrarian, as it seems that there is no ‘all-weather strategy’, or what game theorists would call ‘dominant strategies’. So how can you tell when it is time to stop hoarding toilet paper or to start buying back into European banks? After seeing that herding shows the powerful influence of narratives on human behaviour, the answer is quite simple: the time is ripe to shift when the narrative breaks down or shows serious cracks. The narrative cracks when empirical evidence no longer supports it or when the costs of maintaining it get prohibitively high. The first point is about empirical analysis, the second one is about valuations. Let us consider them in turn.

The narratives break down when fundamentals change
If retail shops fill up their shelves with hygienic paper every single day, the narrative of supply breaking down will eventually be heavily questioned, especially after consumers have a basement full of stock. So empirical evidence would undermine the existing narrative accordingly and replace it with a new one. In this case, the new narrative would possibly be along the lines of “supply is assured despite a pandemic raging out there”. Alternatively, an easing of the pandemic by itself would reduce the panic of buying indiscriminately. In the case of European banks, a change in the narrative would come from announcements about major deregulation, from higher rates in Europe that would help banks’ earnings to recover, or from other shifts in news flow about changes in fundamentals.

Valuations as a signpost
In the investment world, another dimension could come even earlier than a change in fundamentals: the fact that valuations get excessive and the irrational bubble pops even before that happens. This has been the case in most investment-related bubbles. In the late 1980s, the value of real estate in a single quarter of Tokyo was reported in excess of the value of all real estate in California. At that stage, investors realised that the narrative of ever-climbing prices in Tokyo real estate was getting thin. For this reason, asset prices provide such precious information. When put into relation with other data, they give priceless information about a particular situation, which is also why long-term investors place very high importance on valuations in their decision-making. This is exactly the appeal of contrarian investing that pays off after broad-based narratives get revised by new facts.

Three conclusions
It is quite unlikely that the pandemic of 2020 will be viewed as a blessing in disguise, but it may hold valuable lessons on many levels. First, it reveals that what may seem like irrational behaviour at first glance may in fact be rational behaviour, i.e. following the behaviour of the rest of the crowd. Second, contrarian investors should stick to their guns and be either extremely short-term- or extremely long-term- oriented. And third, the signal to switch behaviour is when the narrative breaks down or valuations signal that it will do so soon. On that note, let us hope that the next great crisis is in the distant
future, and if it happens, that it will create some fonder memories than the recent one.