Robert Shiller on Market Declines, Particularly the Latest

We found Yale economist Robert Shiller’s article, “Fears, Not Facts, Drive Global Markets,” thanks to Economist’s View.

As much as we agree with Shiller’s conclusion (as author of the book “Irrational Exuberance,” he is considered an expert), that the size and seeming suddenness of market declines can feed on themselves, we don’t agree with the suggestion he makes, that fear operates in a vacuum.

The reason that the change of sentiment has been so sharp is that the preceding optimism and complacency were so far out of line with the facts. Investors were well aware of the volumes of cash going into risky assets of all sorts, asset inflation, global imbalances, high corporate profits heavily dependent on disinvestment. What they might not have recognized, but could have without too much difficulty (meaning had they been doing their jobs) was that the housing recovery was overstated.

And some investors did know better, did know full well how precarious things are, but stayed in the market because their track records would suffer if they pulled out too early. One pro describes himself as a “fully invested bear.”

So the market shock took hold because there was underlying speculative froth. And now that participants recognize that things may have gotten out of hand, some are looking more intently than usual at data releases for signs of what to do, while others (per Shiller) as influenced by market psychology as much as fundamentals. That’s why the words and actions of the Fed are taken so seriously at junctures like this. Confidence is everything.

We also don’t agree with Shiller’s assertion, based on his survey, that the 1987 crash had no specific trigger. Retrospective surveys like that are notoriously unreliable unless there is a significant investment in quizzing representative interviewees to develop effective yet non-leading questions and “validating” the survey instrument. The very well researched Brady Commission report pointed to two specific news events that set off that meltdown.

From Shiller:

THE sharp one-day drop in the Chinese stock market on February 27 apparently had an enduring effect on major stock markets around the world…

This large and enduring effect has surprised many, since the “story” about the Chinese drop – that the trigger was a rumor that China’s government, concerned about speculation, planned to impose controls on the stock market – seems to have no logical relevance elsewhere.

But, unless one believes that stock markets move only in response to information about economic fundamentals, there really is no reason to be surprised. One-day drops in important stock markets have always had enduring and general effects, owing to market psychology.

If history is any guide, markets can be severely destabilized by one-day drops, which make powerful stories that have more psychological salience to investors than much larger drops that occur over longer time intervals.

For example, people were really agitated when the Dow dropped 3.8 percent on December 6, 1928.

No news story that day discussed economic fundamentals or gave a clear indication of the cause of the decline, relying instead on sensational prose – “the house that Jack built threatened to topple over” and “traders were quaking in their boots.”

But the December 6, 1928, event began a sequence of increasingly severe one-day drops in the Dow over the course of the following year.

Despite a generally rising market, the Dow fell by 3.6 percent on February 7, 1929, 4.1 percent on March 25, 4.2 percent on May 22, 4 percent on May 27 and August 9, 4.2 percent on October 3, and 6.3 percent on October 23, before the infamous “Black Monday” crash.

On each occasion, newspaper accounts further established the 1929 market psychology. The story was always that speculation in the markets had government leaders worried, which is, of course, essentially the same story that we heard from China on February 27.

The historical parallels do not stop there. On September 11, 1986, the Dow dropped 4.6 percent, the steepest one-day decline since May 28, 1962.

In 1986, I thought very hard about what could have caused it. I wondered what people were really thinking, apart from what could be read in the newspapers.

I sent out a short questionnaire to 175 institutional investors and 125 individual investors in the United States.

I asked, “Can you remember any reason to buy or sell that you thought about on those days?” The response rate was 38 percent, and no reason was repeated by more than three respondents, except the stock-market drop itself.

This, and a more elaborate questionnaire that I sent out after the next “Black Monday” crash on October 19, 1987, convinced me that nothing more sensible is occurring than just what newspapers describe: Speculators, responding to changing market prices, and fearing further changes in the same direction, simply decide to bail out.

The actual decision to do so often can wait until the next stimulus, that is, the next day that a big drop occurs – hence, the possibility of a sequence of large one-day declines.

Unfortunately, this behavioral theory of stock market movements is not amenable to easy quantification and forecasting. The bright side is that one-day stock market declines occur more commonly as isolated events with no long-term repercussions.

So investors must now hope the latest episode will be forgotten – unless hope succumbs to market psychology.

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