Wednesday, February 28, 2007

Market Jitters

Barry Ritholz wonders today about the spike in his blog's traffic yesterday as markets around the world were losing value. I admit that I contributed to his site's traffic as I used these three posts to explain to my undergraduate finance theory students how to try to make sense of large market movements. We are passed the lectures on bubbles, noise trading, and herd behavior, and so we spent only a little time assessing what occurred.

In the first of these linked posts, Barry contrasts the explanation based on China's 8.8% drop with other events that also occurred yesterday, including news stories related to subprime lending and the weakness in the Advanced Durable Goods report. I don't buy any explanation based on China--its stock market is too small, the effect on other Asian markets was not particularly large, and weakness in the Chinese economy would indicate that we are likely to be able to run our trade deficit with China at lower cost. That shouldn't be bad news. I don't know enough about the subprime lending issues to know how important they were--I think it's a fairly marginal part of the real housing sector, so I'm skeptical there as well.

That would leave us with the weakness in durable goods. If this is to be the explanation, then it is interesting that it generated a downward movement. Typically, when there is unexpected strength in the other major monthly economic releases like GDP and Employment, the market does poorly. The rationale is that unexpected strength in the economy will make the odds of a Fed increase in short term interest rates more likely. That increase, in turn, depresses stock market values. The same process, probably to a milder extent, should operate in reverse for unexpected weakness in the macroeconomy.

So this durable goods report was unexpected weakness--why didn't the market hold steady or even go up? According to this view, the answer would have to be that, unlike GDP and Employment, the Durable Goods report also tells us directly about economy-wide investment and thus future business growth. So weakness there could be greeted not just with the lower inflationary expectations but lower profit expectations as well. Plausible--a good event study to do for an undergraduate finance major, perhaps.

My preferred explanation is that we have plenty of investors, both individual and institutional, who treat stock markets like a speculative exercise. There is noise trading and herd behavior aplenty, and so a drop of over 3% in the U.S., and larger drops in more thinly traded markets, shouldn't be all that surprising. I didn't even check my portfolios yesterday.

Via the Opinionator, here are some anecdotes from Daniel Gross about the way some professional investors in China viewed the events:
Special World is Flat bonus anecdote. Note the way Chinese analysts have quickly assimilated the technique, developed over several decades by U.S. analysts, of using fatuous cliches to explain baffling market activity.

''The most important reason for today's decline was pressure for profit-taking,'' said Peng Yunliang, a senior analyst at Shanghai Securities.

''People viewed 3,000 as a psychological benchmark. It's understandable they might want to pull back after the market hit that peak,'' Peng added.

It truly is a global capital market.


Jon Shea said...

I've heard a number of times now that there was some kind of glitch in the Dow reporting system that resulted in a higher-than-actual score for a while, until a sudden ~200 point correction in less than a minute. Do you think this might have anything do do with anything?

Traders who were pessimistic for what ever reason may have been expecting the market to drop, and may have traded against this expectation. If the Dow wasn't reporting correctly, then maybe they didn't get an important feedback parameter and didn't fully appreciate the magnitude of the drop. Traders may have believed the market was higher than it actually was, and continued to trade against a fall that had already happened.

Jon Shea said...

I just read Barry Ritholz's posts. While I don't think the computer glitch was an underlying of the fall, but certainly it effected trading _somehow_. From 2:00 to 3:00 yesterday I bet some people looked at the Dow and said "Man, the market just is not dropping to where I think it should be. I'm going to sell some more stuff." That would certainly help explain why the market started to come back up immediately after the computer correction.

I'd be interested in seeing what the Dow would have looked like yesterday if it were correctly tabulated all day long. If it fell further than the S&P and Nasdaq did, then that would seem to support my view.

Indeed, from google finance it looks to me like the drops from morning value to daily minimum yesterday was:

Dow: 3.29%
S&P: 3.02%
Nasdaq: 2.52%

knzn said...

"Typically, when there is unexpected strength in the other major monthly economic releases like GDP and Employment, the market does poorly."

I think the word "typically" glosses over a lot of variation in that response over time. Particularly in the past decade, there have been times when stronger-than-expected economic releases have been seen as good news for the market. The market wants a Goldilocks economy, and depending on the what the perceived alternative is, a strong report can mean either "too hot" (Fed tightening) or "not too cold" (higher profits).

I'm not saying that this durable goods report was the main cause of the market decline, but to the extent that it did contribute, I'd say one critical aspect of it was the severity. A report just slightly below expectations might have been good news ("not to hot"), but a severe negative surprise was bad news ("too cold").