Ignore Stock Market Volatility

Jim Surowiecki has a great line this week, in his column on stock-market volatility:

For now we’re stuck in a Yeatsian market: the best lack all conviction, while the worst are full of passionate intensity.

The sentiment here is spot-on. Right now we’re in a William Goldman market: nobody knows anything. In such a situation, one might expect that traders and investors both would tread cautiously, and the market would make no sudden moves. Instead, volatility has gone up dramatically, and 2% swings in the stock market are commonplace.

It’s worth noting, however, that Surowiecki’s column is grounded in a pretty strong version of the efficient markets hypothesis. He talks about "real news" twice and "new news" once, as drivers of stock prices, and contrives to act surprised that sometimes stocks move dramatically even when there’s no news of either description.

But in order for this to be at all surprising, you have to believe that stock prices reflect all the information in the market, and that in order for stock prices to change, new information (aka "news") has to arrive. It’s a belief which is understandably attractive to journalists, who traffic in news. But it’s also a theory which remains stubbornly immune to empirical validation.

Along any given timeline, there will be points at which big news events happen. And there will be points at which big stock-market moves happen. But the two don’t overlap nearly as often as you might think, and indeed when they do overlap, the direction of the stock-market move is often counterintuitive.

As Surowiecki says, what we’re witnessing right now is symptomatic of stock-market behavior broadly. Market participants tend to "herd"; down markets tend to be accompanied by increased volatility; and if anybody wants to make money in this market they’re going to have to be willing and able to change their directional bets frequently.

There’s also the fact that a credit crunch is a classic crisis of confidence, which means that big stock moves really are news, in and of themselves. Creditors are in control right now: any leveraged company which can’t fund itself in this market is toast. And creditors keep a very close eye on the stock market: if a leveraged company’s share price is strong, there’s probably relatively little to worry about. If it’s weak, however, that implies that the equity cushion is being eaten away fast, and that it might not be such a good idea to roll over that company’s debts.

If the stock of Lehman Brothers, say, is falling, then, that’s in and of itself reason for its creditors to be worried — which in turn is reason for the stock to fall further.

But the real lesson to be learned from all this stock-market volatility is that nearly everybody attributes far too much importance to one-day or one-week or one-month moves in stock-market indices. Writes Surowiecki:

Precipitous falls in the market have frequently been followed immediately by sharp rallies, and vice versa. And, while some of these moves have been occasioned by real news, more often it’s been impossible to tell just what made investors so damn exuberant or so gloomy…

In this market, the same traders who on Tuesday seem convinced that the apocalypse is nigh are, on Wednesday, just as sure that we’ve weathered the storm.

Who says that investors are being particularly exuberant or gloomy? The only evidence is short-term moves in the stock market, and once again you need to believe in some kind of efficient markets hypothesis to work backwards from a market plunge to gloomy investors.

Yes, it’s conceivable that if a whole bunch of investors woke up one morning in a particularly gloomy and pessimistic mood, then the stock market would fall. But that’s not what happens in real life. Think back to the last time you bought stocks: were you particularly happy or exuberant? What about the last time you sold stocks: were you gloomy or sad? Things are never as simple as that. The concept of "market psychology" is a wonderful invention for journalists desperate for a narrative, and is a great sales tool for people who believe in technical analysis. But again it’s basically an unfalsifiable fiction, backed up with almost nothing in the way of empirical evidence.

Surowiecki says that "in the long run volatility is a very bad thing, because it makes ordinary investors less inclined to trust markets". Which is true largely because the financial press insists on reading far too much into short-term stock-market moves.

The path of the stock market is naturally bumpy, especially in down markets. If financial journalists in general, and the talking heads on CNBC in particular, were a bit more sanguine about daily volatility, then maybe ordinary investors wouldn’t be worried. But there seems to be an insatiable demand for news about what the stock market is doing today, complete with accompanying narratives about how a 30-point decline in the S&P 500 is evidence of broad-based pessimism about the global economy, or something else along those lines.

The cure for this disease? Don’t read, watch, or listen to any stock-market reports. They never contain any useful information, and you’re much more likely to mistake noise for signal than you are to learn something substantive.

This entry was posted in investing, stocks. Bookmark the permalink.

5 Responses to Ignore Stock Market Volatility

  1. 1205lwf

    Do you think I can stay custom, conventionalities, nor even of mortal flesh.

  2. uggboots says:

    we know winter is very cold,we began ? We professional supply

    ,

    ,

    ,

    ,

    ,

    online,this winter the best way to keep your feet warm is to get a pair of ugg Boots.

  3. zjz says:

    wo providesuch as

    .

    if you want to buy and

    AND if you are crazy love basketball you may be intrested in our basketball shoes

    .buy basetball shoes our shop is best. it is a big amazing.

    now in our website, choose our shop. our goods

    are all of free shipping.

Comments are closed.