Stocks’ gyrations defy explanation
Investors throw market fundamentals out the window and succumb to emotion amid contradictory signals from the economy
By Nathaniel Popper, Los Angeles Times
July 24, 2010
Reporting from New York
Jim Paulsen has a PhD in economics and more than a quarter-century of experience as an investment strategist, but he’s finding it harder than ever to make sense of the stock market.
Paulsen, 52, was taught to evaluate investments based on “the fundamentals” — the nitty-gritty statistics in economic reports and corporate financial statements.
But in the last couple of years, and especially the last few months, he said, those fundamentals have told him little about the future movement of stock prices. Instead, the market seems now to move more than ever on waves of emotion and sheer momentum.
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“At the end of the day, I live by the credence that fundamentals will win out over time,” said Paulsen, chief
investment strategist at Wells Capital Management, a Wells Fargo & Co. unit that manages more than $300 billion in investments.
“But, you know, now sometimes I just feel like I should give back my degree and become a psychologist,” he said.
The complaint that the stock market is irrational is as old as the market itself, but many investment professionals agree with Paulsen that there is something different about this time.
They cite how stocks plunged almost in unison during the financial crisis and Great Recession, then surged in concert starting in March 2009, only to fall back in the market “correction” that began three months ago.
Unusual volatility in share prices also has unnerved and frustrated market analysts. Stocks have shown the ability to fall sharply one day despite little in the way of news to account for such a decline — and then shoot up the next day, also with little apparent justification.
“Many of these swings in recent times really have nothing to do with fundamentals,” said Avanidhar Subrahmanyam, a professor of finance at UCLA’s Anderson School of Management.
After hitting a 19-month high April 26, the Dow Jones industrials sank more than 1,500 points, or 14%, in less than 10 weeks as investors worried about global fallout from the debt woes of some governments in Europe.
In the same period, the Standard & Poor’s 500 stock index lost 16% — despite persistent projections that the steady rise that began in early 2009 of the earnings of companies in the index would continue through the end of this year.
Goldman Sachs Group Inc., widely considered the savviest trading house on Wall Street, acknowledged this week that its second-quarter earnings were undermined by the challenge of staying on top of the market’s gyrations.
This month, stocks quickly erased nearly half of what they lost in their 10-week slide, despite little change in the economic picture in the U.S. or in Europe. Since then, the market has been moving sharply in both directions — sometimes driven by data such as earnings reports but other times seemingly acting on emotion.
On Friday, the Dow jumped 102.32 points, or 1%, to 10,424.62, after some U.S. companies posted healthy results, General Electric Co. boosted its dividend and European regulators said that only a handful of banks had failed a round of “stress tests.”
Terrance Odean, a finance professor at UC Berkeley, ties the market’s behavior this year to the aftermath of a once-in-a-lifetime financial crisis.
“This generation of investors had not ever had an ‘it’s 3 o’clock in the morning and I can’t sleep’ sort of scare,” he said.
The financial crisis also has made companies more vulnerable than usual to macroeconomic factors, such as credit availability and changing consumer patterns. That has made stock prices seem to move more often as one, rather than in response to company or sector specific data.
“2008 was all about getting out [of the stock market] and asking questions later, and 2009 was about getting back in and asking questions later,” said Bob Doll, chief investment officer at New York mutual fund
giant BlackRock Inc. “There is this macro thing that is dominating company fundamentals.”
It has not helped that the economic possibilities often appear contradictory, from a “double dip” back into recession to a new global boom sparked by growth in emerging markets.
“The range of outcomes has probably never been this wide since 1945,” said Jason Trennert, chief investment strategist at Strategas Research Partners. “You go into one meeting and people bend your ear about deflation, and the next meeting it’s all about inflation. And they both make very good points. And they are both entirely conceivable.”
Finance textbooks teach the theory that the stock market is an efficient information machine, with prices immediately reflecting each new piece of fundamental data.
On the other hand, entire schools of thought have been built on the premise that the market really isn’t so efficient.
The relatively new field of behavioral finance holds that investors often act more emotionally than logically.
Even if irrational factors are playing a greater role now than they usually do, the market is adhering to a pattern seen after previous crises, said Meir Statman, a finance professor at Santa Clara University.
“There are always two drivers to this car that we call the market — one is fundamentals and the other is emotion,” he said. “The relative powers of those two drivers in pulling on this steering wheel always vary over time.”
Some professional investors ignore fundamentals all the time, relying instead on so-called technical analysis, which looks only at past market data such as prices and trading volume in an effort to discern patterns that will predict what the market will do next.
At investment industry conferences these days the conversation is more likely to be about such technical
issues rather than companies’ real-world business prospects, said Jim Swanson, a strategist at Massachusetts Financial Services.
“I get up and give speeches and I say, ‘The fundamentals in these companies are good,'” he said. “Right now, no one is interested in that.”
Swanson holds out hope that fundamentals will reassert their hold on the market. “I don’t think this can last forever,” he said, “but I just don’t know.”
There are legitimate reasons to wonder whether the market will return to something that feels more normal.
Although technical analysis has been around for decades, it has become more prominent as the computers used to crunch data have
become more powerful. So-called high-frequency traders — who are believed to account for most of the market’s trading volume — consider technical factors only.
Many experts blame the growing dominance of such strategies, also used by many hedge funds, for the apparent unhinging of stock prices from fundamental factors and for making market moves in either direction more extreme. High-frequency traders were pointed to by many as a cause of
the still-unexplained “flash crash” on May 6, in which the Dow sank 700 points in less than five minutes.
Doll of BlackRock ad-
vises patience, saying fundamentals will regain their prominence once the panic passes.
“Tell these people to wash their face with some cold water,” he said. “Things are going to be OK.”