Sunday, October 5, 2008

Explaining the Market....

The last three weeks have been a boon for financial reporters. All of a sudden, they get the front page stories in their newspapers, a little akin to being the weather forecasters in the middle of a hurricane. At the end of each day, after another violent market move, they go to the experts (academics, practitioners) and ask them for reasons. They get the obligatory: "The market went up (down) because...." I have always been skeptical of this Monday-morning quarterbacking, and last week illustrates why.
On Monday, the market was down 778 points and the culprit was so obvious that experts were not even consulted. The bailout bill failed to pass in the House, and the market fall was attributed to this failure. The rest of the week was less explainable. On Tuesday, when there was little news about the bailout, the market bounced back up almost 500 points. On Wednesday, when things looked rosier for the bill's success, the market was down again. On Thursday, after the senate had passed the bill, the market did nothing. (Boring never felt so good.) On Friday, the bill finally passed around midday. Good news, right! The market promptly swooned. 
There are several reasons why the market is so difficult to decipher. First, all events have to be measured relative to expectations. There is no good news or bad news in absolute terms but only in relative terms. An earnings increase of 50% at Google may be bad news, if investors were expecting an increase of 75%. A drop in earnings of 30% at Ford may be good news, if investors were expecting a drop of 50%.  Second, there are so many events swirling around markets that it is difficult to pinpoint exactly what caused the market to move on any given day: Was it the weakening dollar? Higher interest rates? Unexpected inflation? Third, a great deal of what happens on any given day cannot be explained; putting a reason on a big move after the fact allows us to feel better about ourselves (as investors) and a little more in control of our destinies. 
Do I think that experts should stop trying to provide explanations for market moves? Not at all. In addition to their entertainment value, these explanations may help markets put the past behind and move on... 


ryanshaunkelly said...

Barack John
Left and rights of passage
Black and whites of youth
Who can face the knowledge
that the truth is not the truth?
Obsolete Absolute

Ron Ralph
Cruising under your radar
Watching from the satellites
Take a page from the red book
and keep them in your sights
Red alert Red alert


Little Bear said...

Great insights. Thanks for creating this blog.
Do you have any insights or comments on the Fed offering to pay interest on reserve requirements?

Rhys Kidd said...


A view I've long considered is that these talking-heads' opinions of the market movements, often during evening news, increases liquidity from lay investors that would otherwise remain on the sideline.

While practitioners in finance might wince at descriptions like "the ASX gave the thumbs up to the bail out package", it uses terminology that - while lacking in precision and depth - might serve its purpose and be good enough in the circumstances to make investing more accessible to lay investors.

Your thoughts?

Aswath Damodaran said...

I m not sure what to make of the Fed offering to pay interest on reserve requirements. There is a whiff of desperation there.. and who can blame them?
As for the talking heads, I agree with you entirely. If I had my say, I would have tell investors and traders never to watch financial news. The advice you get is seldom worthwhile and you are often tempted to react to events you should not be reacting to.

Wishbone said...

A thought i have on the same is that news like anything else is a function of free markets. Had the news/views/advice given by the Financials Pundits been of some worth they would ideally be never so cheap or free....
Any news/advice worth its salt would have a premium attached to it..


Sergei said...

About why the Fed wants to be able to pay interest on deposits... I think a good explanation is provided in Economist's article from Oct 2 called 'Plan B'. The relevant part starts in paragraph six ("When the Fed makes loans...")

Little Bear said...


Thanks, I will go back and look at it!

ojb said...

... "In addition to their entertainment value, these explanations ..."

Indeed. I also find that the value of said entertainment highly correlates with volatility, eg.

10am: "Dow up 200 points as investors celebrate XYZ's earnings announcement!"

2:30pm: Dow down 250 poinrs as investors mull XYZ's earnings announcement!"

aniket said...

Sir, I know this is a really old post (though eerie similarities have started reappearing) I would love to have your take on the adage that in the short term the market is frequently done digesting the developments before they even occur.