The known unknown about stock markets

When they find out I am an economist, people often ask me what I think is going on with the stock market!

Sometimes this is just a conversation starter so that they can tell me what they think, but at other times it is a genuine question, based on the assumption that an economist must have some special investment tips or insights into the stock market. This assumption is misplaced. While economists do have a good understanding of how markets function, they do not have any “insider” knowledge about the exact ups and down of the stock market on a given day. In this case, the real essence of knowledge is to know that, in fact, one cannot know! While this may be disappointing to someone looking to make a quick profit on a non-existent expert insight, what economists do know about the stock market is quite helpful in planning one’s forays into the stock market.

The stock market is, after all, a market. The forces of demand and supply come together to determine the prices of various stocks. Thus, the market price of a particular stock at any point balances the number of shares people wish to hold of that stock with the number of shares other people wish to sell. The reasons behind people demanding to buy or sell a stock can be varied. For instance, some person may wish to sell his stocks in order to pay for a new house he / she wants to purchase. However, the number of people indulging in such specific idiosyncratic reasons at any point in time is likely to be small.

One plausible reason why people wish to buy or sell a stock is that they believe the present value of the stream of returns on that stock is higher or lower than the current price of the stock. In other words, they are likely to buy a stock they think is undervalued and sell the one that is overvalued. The stock price is indicative of the collective beliefs about the future returns of the stock.

One source of people’s beliefs is their information. Individuals may have specific insights about some area of economic activity or even a specific firm, which makes them take a more or less optimistic view of a particular stock. In this sense, the stock market “aggregates” the diverse information held by people throughout the economy into the stock price. It has been argued that the stock markets are incredibly efficient in this aggregation of information. In a famous example, it was found that minutes after the Challenger space shuttle disaster, the stock of the company that supplied the small faulty piece that was later found to be the cause of the crash, fell precipitously. In some sense, the stock market “knew” instantly what a Presidential Commission with distinguished experts took years to ascertain.

One implication of this efficient market hypothesis is that only those with new information and acting quickly can gain within a fleeting window of opportunity while there is a temporary discrepancy between a stock price and its theoretical “true” value. Another implication is that the stock market cannot be consistently predicted on a day to day basis. If people expected the stock price to go up, say the next day, then they would like to get in and buy it today itself, therefore raising the stock price today instead of tomorrow. Thus, the ability to beat the stock market on a day to day basis requires either luck or access to insider information, which not many have, nor are legally permitted to have. This is why, in response to the question asked at the start of this piece, I (or any person for that matter) would not be in an authoritative position to tell exactly how the stock market will behave, and if one indeed knew, it is unlikely they will tell you.

Interestingly, the efficiency of the stock market in aggregating information may, on a day-to-day basis, lead the stock prices fluctuate a lot. Expectations can be self-fulfilling. When a stock price is going up, some people may infer, as per the efficient market hypothesis, that there is some piece of good news about the stock, and in order to get in on the action, decide to buy it. However, this behavior itself can increase the stock price, which may make some other people convinced that there is indeed some good news, which makes them want to join in! This can cause a stock to rally up and up while there is no or little good news about it. Ditto a stock crash. In many cases, the big fluctuations in the market come from people trying to guess, and second guess, one another. When this happens, it’s more about mass psychology than economic fundamentals.

So next time you meet a psychologist, you may want to ask him / her what is going on with the stock market in the short run, instead of asking me as an economist!