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Monday, March 19, 2007

Was the Recent Stock Market Decline the First of Many?

Robert Shiller tries to make sense of the recent decline in stock markets around the world and determine whether it was a one-time isolated event, or whether there are more declines yet to come. Unfortunately, history does not provide any clear guidance. Most sharp and sudden declines are one-time events, but not always:

Fears, not facts, drive global stock markets, by Robert J. Shiller, Project Syndicate: 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. ... In London, the FTSE 100 was off by 2.3 percent. In New York, the Dow Jones Industrial Average was down by 3.3 percent. ... Moreover, two weeks later, all these markets outside of China were down from 4.3 percent to 7.8 percent compared to their close on February 26.

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. ... 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.

    Posted by on Monday, March 19, 2007 at 01:32 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (36)


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