Barry Ritholz wonders today about the spike in his blog's traffic yesterday as markets around the world were losing value. I admit that I contributed to his site's traffic as I used these three posts to explain to my undergraduate finance theory students how to try to make sense of large market movements. We are passed the lectures on bubbles, noise trading, and herd behavior, and so we spent only a little time assessing what occurred.
In the first of these linked posts, Barry contrasts the explanation based on China's 8.8% drop with other events that also occurred yesterday, including news stories related to subprime lending and the weakness in the Advanced Durable Goods report. I don't buy any explanation based on China--its stock market is too small, the effect on other Asian markets was not particularly large, and weakness in the Chinese economy would indicate that we are likely to be able to run our trade deficit with China at lower cost. That shouldn't be bad news. I don't know enough about the subprime lending issues to know how important they were--I think it's a fairly marginal part of the real housing sector, so I'm skeptical there as well.
That would leave us with the weakness in durable goods. If this is to be the explanation, then it is interesting that it generated a downward movement. Typically, when there is unexpected strength in the other major monthly economic releases like GDP and Employment, the market does poorly. The rationale is that unexpected strength in the economy will make the odds of a Fed increase in short term interest rates more likely. That increase, in turn, depresses stock market values. The same process, probably to a milder extent, should operate in reverse for unexpected weakness in the macroeconomy.
So this durable goods report was unexpected weakness--why didn't the market hold steady or even go up? According to this view, the answer would have to be that, unlike GDP and Employment, the Durable Goods report also tells us directly about economy-wide investment and thus future business growth. So weakness there could be greeted not just with the lower inflationary expectations but lower profit expectations as well. Plausible--a good event study to do for an undergraduate finance major, perhaps.
My preferred explanation is that we have plenty of investors, both individual and institutional, who treat stock markets like a speculative exercise. There is noise trading and herd behavior aplenty, and so a drop of over 3% in the U.S., and larger drops in more thinly traded markets, shouldn't be all that surprising. I didn't even check my portfolios yesterday.
Via the Opinionator, here are some anecdotes from Daniel Gross about the way some professional investors in China viewed the events:
Special World is Flat bonus anecdote. Note the way Chinese analysts have quickly assimilated the technique, developed over several decades by U.S. analysts, of using fatuous cliches to explain baffling market activity.
''The most important reason for today's decline was pressure for profit-taking,'' said Peng Yunliang, a senior analyst at Shanghai Securities.
''People viewed 3,000 as a psychological benchmark. It's understandable they might want to pull back after the market hit that peak,'' Peng added.
It truly is a global capital market.