How do media narratives influence the financial markets?

What was the motive behind your analysis (1) of media narratives and their impact on financial markets?

Intuitively, we expect the stories that investors read, share and talk about with their friends, colleagues and counterparties to influence their macroeconomic views, impact their decisions to buy or sell assets and in turn, affect asset prices. Today, coverage of geo-political risk, supply chain disruptions, rising inflation, and rapid deterioration of the climate are all examples of highly prevalent narratives influencing investment decision-making. However, recent works including a seminal book by Nobel laureate Robert Shiller (2) develop the theory of narrative economics that is often demonstrated with powerful examples, but my co-authors and I thought that the literature has a gap insofar as connecting narrative economics to financial markets and coming up with investment management applications. We wanted to explore whether narratives could be systematically quantified from media coverage data and if so, whether investors can use media-based measures of narratives to improve their understanding of aggregate- and firm-level risks, their ability to gain (or hedge) exposures to evolving stories, and ultimately achieve better investment outcomes.

What important findings did your analysis reveal?

The first, and perhaps most important finding is that a media-coverage-based approach to quantifying narratives can explain aggregate market dynamics. For example, the measure of the Market Crash narrative is shown to predict future market returns beyond lag returns and traditional factors including the VIX (3). This is significant for two reasons. First, it means that digital media accurately capture the evolution of narratives as they develop in real-time. Second, the results suggest that investors do indeed respond to changes in narrative sentiment and narrative intensity whereas it could have been the case that the narratives are only reflections of past market actions. Inspired by these findings, we explore potential portfolio applications including risk reduction and return enhancement. For example, we find that narrative insights can improve asset allocation strategies. More generally, the paper introduces a framework by which security-level narrative-sensitivities are systematically estimated to provide investors with basic tools to hedge or to load on thematic risk exposures such as an emerging pandemic or the military escalation of an international conflict.

Did any of your findings surprise you at all?

Some findings were surprising. For example, one would expect that the most significant thematic market drivers would be those that attract the highest media attention. While this is certainly the case for some narratives, other stories are able to explain a significant amount of market-wide variations without attracting as much media attention (measured by the intensity of media coverage). Indeed, we found it a bit unexpected and think it may actually hint to two possible distinct narrative “life-cycle” paths. According to the first path, a certain story becomes top-of-mind to investors and catches hold after it is covered intensely by the media (in other words, media lead with the story and the market follows). The other possible path suggests that the markets respond to emerging stories first and the media catches up to its magnitude with some lag. Either possibility could lead to scenarios where a narrative getting little media coverage at a certain point in time may still be highly relevant to investors. As a side note, this “life-cycle” idea inspires us to study the interactions between media coverage intensity of narratives and their market-impacts, which we started tracking using a cool visualization dubbed “Narrative Maps”. I’d have more to share on that project in a few months, stay tuned.

(1) Bhargava, Rajeev and Lou, Xiaoxia and Ozik, Gideon and Sadka, Ronnie and Whitmore, Travis. Quantifying Narratives and their Impact on Financial Markets (July 15, 2022). http://dx.doi.org/10.2139/ssrn.4166640

(2) Shiller Robert J. - Narrative Economics: How Stories Go Viral and Drive Major Economic Events (2019). https://press.princeton.edu/books/hardcover/9780691182292/narrative-economics

(3) The VIX is a real-time index representing a part of the market's expectations, see https://www.investopedia.com/terms/v/vix.asp