In what ways do prices take into account the fundamental economic data? Some say that market price always reflects the state of the real economy. That point of view is a travesty of reality. Others contend that given the permanently observed lack of connection between share prices and the economic basics, to see one is not to believe the other. The one obvious fact is that rather than being influenced by these data, prices are largely determined by the expectations that speculators have of them.
So how does the news affect prices? At a forum at Wharton Business School in October 2001, Professor Richard Marston (who teaches there) stated: ‘‘The economy itself, and expectations about it, are what is driving the stock market right now.’’ Right now? Isn’t this always the case? Expectations continually drive the market. Let’s look at what happened in September 2001. During the first five days of trading after the terrorist attacks on the World Trade Center and the Pentagon, the Dow Jones Industrial Average plummeted 14.25 percent, the greatest weekly loss in 61 years. Since the beginning of 2001, the financial markets had been undergoing a phase of ‘‘bubble’’ bursting, in contrast to the euphoria that had characterized the previous few years. Taking as a reference the US-based computerized network for price quotations known as NASDAQ, we may note that it took 14 months to rise from 2000 to 5000 (11 months for this index to rise from 2000 to 3000 points, 2 months from 3000 to 4000 and 10 weeks from 4000 to 5000) and 22 months to bring it down from its maximum (5048.62 on December 3, 2000) to 1694.27 (on September 10, 2001). This fall may have been masked, but it was cumulatively tantamount to a crash – and it had yet to run its course. The atrocities on September 11 and the closing of American stock markets for the following four days accelerated this pronounced trend; on September 21, 2001, the index stood at 1423.19. Given what had been going on for a year, one could be led to believe that the 16 percent loss in one week would have taken place in any event, but might have been strung out over a period approaching a month. After all, alarming news concerning the American economy had been lowering ongoing expectations. What happened was that the attacks compressed the impact of the negative economic news and tidings. But then, in what ways are expectations usually related to economic evolution? Here again, we anchor ourselves in the past and go on to suppose that previous links between expectations and the real economy will be reiterated. During the Wharton forum, Richard Marston also stated:
Because investors try to anticipate future events, stocks tend to rebound before the economy does. It is hard to make any forecast, especially about the future. But the hardest things to predict are turning points. It’s remarkable how much the market moves after it reaches the bottom.
Marston was putting forward the point that speculators anticipated the ‘‘rebound’’. According to him, from June through October 1990, the Gulf War helped drag the Standard and Poor’s index down by 14.7 percent. And yet over the next six months it rose by no less than 25.6 percent! Fast forward to the summer of 1998, when Russia was in turmoil. During July and August the index registered a 15.4 percent drop, but it rose 30.3 percent over the following six months and 39.8 percent again in the year after the end of the crisis.
Anticipations have similar sources, and it matters little whether the expectations are mathematical or based on probable forecasts. In one case the sequence is the historical mean, in the other historical correlations are used. Psychology is invariably involved and what really matters is the confidence with which we make a forecast – Keynes’s state of confidence, i.e. the risk of our forecast turning out to be wrong. Variance and standard deviation assess the variations in the profitability of a security. Do they constitute measurements of risks incurred when investing in the latter? Not to the extent that they measure pleasant as well as unpleasant surprises. And not to the extent that the future fails to renew the past. Let us examine these two negative answers.
Variability also measures agreeable surprises such as shareholder returns that are higher than expected. Is this risk? In fact risk is limited to disagreeable surprises, but as long as returns remain symmetrically scattered, that is as long as the likelihood of a happy surprise is equal to the likelihood of an unhappy surprise, standard deviation adequately measures the risks incurred. The higher it is, the greater the danger. It is the same with the ‘‘risks’’ of manna from heaven, but prudent investors fear the worst more than they hope for the best.