Market Volatility for Dummies
From the New York Times.
When Bulls and Bears Act Unruly on a Seesaw
By FLOYD NORRIS
Does it make sense for stock prices to plunge one day and soar the next, with little in the way of new information to explain either move?
Maybe not, but it happened this week, just as it did earlier in August. It was the first time in more than four years that the American stock market experienced such wild swings, and could be a harbinger of a reversal of direction in either the stock market or the economy, or both.
Or it could just show that changes in the financial system have left many investors confused about what is going on.
In the past, such wild swings have sometimes indicated that markets were turning in a new direction. In retrospect, there seem to be good reasons for the turnaround. But at the time, there were also plenty of investors who believed that the prevailing trend was sure to continue and jumped in to drive prices in the old direction.
In September 1974, with the economy in a severe recession and the stock market in the worst bear market since the Depression, there was a string of sharp, contradictory moves. Share prices hit bottom in early October, and a strong recovery followed.
In 2000, the bull market was going strong, led by the technology stocks that had soared and made many traders feel rich. The first big reversal came in January, with prices plunging one day and recovering the next. It happened again in April, and again in October. The Internet bubble was finally deflating, and a prolonged bear market was beginning.
By 2002, investors were as depressed as they had been in a generation. The 2001 recession was over, but that was not clear. A series of summer reversals signaled that a bottom was near, and was followed by more reversals in October, November and the following March. The bull market had revived.
But while such reversals can signal major market moves, they can also occur when markets are stirred by changes that leave many investors simply perplexed. The 1987 crash, which seemed at the time to warn of impending recession, now appears to have been caused by a new investment strategy involving stock index futures that led to major selling after the first decline. The strategy, called portfolio insurance, decimated portfolios, but it did not reflect what was going on in the economy. Aided by quick action on the part of the Federal Reserve, the next recession was still three years away.
Similarly, reversals in 1997 and 1998 came amid an Asian credit crisis, a Russian default on debt and problems with a hedge fund, Long-Term Capital Management, whose strategies were not as brilliant as its founders had believed. But they did not presage an end to the 1990s bull market.
This year’s sharp moves have come as investors vacillated over how extensive the effects of the subprime mortgage problems will be. Those problems have led to a sharp contraction of credit markets and to difficulties for a number of hedge funds, but it is unclear if the crisis will also bring on a recession and end a bull market that has sent most stocks well above the highs they reached in 2000.
To some traders, it is ridiculous to expect the entire economy to falter because of problems in the subprime mortgage market. That market is, as President Bush put it yesterday, “modest in relation to the size of our economy,” and the world economy remains strong.
Others are convinced that tighter credit standards will force American consumers to curtail spending, slowing the economy and damaging corporate profits. It is from such contradictory beliefs that the wild days of August sprang.
