One possible reason for market instability (in general)

A stray thought:

Usually when demand increases for something, that drives the price up, which decreases the demand until the price stabilizes.

But this stabilizer seems to work in the wrong direction in financial markets: When demand increases for a stock, that drives the price up, which

*increases* demand -- at least until it is obviously overpriced. When demand decreases for a stock, that drives the price down, which *decreases* demand, inducing more people to sell.

I've heard this notion expressed as follows: "Why is it that when Macy's holds a sale, people rush to buy; but when Wall Street holds a sale, people rush to sell?"

So if I'm right, investor behavior is a natural market destabilizer: Price changes feed back into investor behavior, which tends to push prices in the same direction in which they were already moving. More evidence for this phenomenon is that when stock prices decline, there is invariably a huge outflow from stock mutual funds to bond mutual funds.

In general, when a feedback loop causes instability, reducing the amount of feedback will reduce the instability, often dramatically. When a PA system starts to squeal, turning down the volume just a tiny bit will usually stop it. Which suggests that one way to increase stability in financial markets is to find a way to influence investor behavior in general -- and it probably doesn't need to be very much of an influence.

Reply to
Andrew Koenig
Loading thread data ...

Lately I think about the decline often in terms of, "How much of it is based in panic, and how much is based in at least a crude calculation of declining company earnings?" To me much of the decline is panic- based, driven by what you say above.

But ISTM that it has to be "influence" of such a quality that it has to get to the masses of investors. Which to me means that, even if the influence is simply a small change in investing philosophy, getting enough of the masses to adopt this change is a tall task.

I see market panics as substantially psychological behavior. A Darwinian model works. People are going to lose their shirts from time to time. The more skilled will survive. It is the proverbial (for the liberal arts crowd) shrinking sinusoidal curve of input-output (for the techie crowd), such that society tends towards things getting better overall, insofar as health and well-being are concerned.

Reply to
honda.lioness

Because no one can sell back to Macy's. Making this a comparable situation, let's say I don't own any stocks at this time, just all cash. Then yes I am definitely buying (fact is, I am buying anyway).

Reply to
PeterL

Andrew, you might be interested in reading George Soros's "Alchemy of Finance" where he discusses his concept of "reflexivity" and applies it to a few market scenarios where he made a bundle of money. Engineer-types will recognize it as a feedback loop much like you're describing. If you google reflexivity you'll probably find a lot of stuff by Soros on this topic.

I think you're absolutely right, that drops can lead to drops and vice versa. For lots of reasons, human behavior being one of them, the impact of leverage being another. With banks recently there's this issue of low share prices meaning high dilution when raising new equity-based capital, a sort of death-spiral for equity holders during hard times (not just with banks, though their capital needs are unique because of the way they're regulated). Credit-rating downgrades trigger provisions in debt covenants that put more stress on company cash flow, leading to more credit-rating downgrades. The 1987 crash is blamed on portfolio insurance and the resulting waves of selling. Many examples here...

-Tad

Reply to
Tad Borek

Overshoot is proposed to be a rational process that is normally in the self interest of participating investors in an article "Why do share prices move relentlessly in one direction?" at

formatting link
652255 .They say "a new working paper by researchers at the London School ofEconomics (LSE) suggests that the momentum effect is still consistentwith the idea that investors are rational.". In fact they find itharder to explain the mechanisms of eventual "reversion to the mean"3-5 years later than overshoot. I normally enjoy the cycles of momentum, but not at the crazy speed and extent such as recent tech, oil, and financial bubbles. Maybe modern active investment tools are particularly supporting the rationality that the paper describes.

Reply to
dumbstruck

at

formatting link
652255.> They say "a new working paper by researchers at the London School of> Economics (LSE) suggests that the momentum effect is still consistent> with the idea that investors are rational." I think all the authors are suggesting is that almost any action can be argued to be in one's self-interest.

The article (and I imagine the paper cited) are excellent justifications for further dabbling in timing using momentum tactics. I say dabbling, timing, and momentum approaches are all irrational approaches to investing.

If one wants to sleep at night, one bets on economies, not short-term fluctuations.

This enjoyment is like that taken from waiting for the next card in blackjack. Gambling is this way. Investing is not.

Reply to
honda.lioness

IMHO, the assumption that investors are rational is false on its face. How many truly rational investors (not effected by emotions such as fear and greed) do you know? I know this market scares me, even as I'm saying "stay the course". I know I got greedy in 2000.

-- Doug

Reply to
Douglas Johnson

No, that interpretation of me and the article is incorrect. You can just click on the article citations for an executive summary or the paper itself (from "The Paul Woolley Centre for the Study of Capital Market Dysfunctionality" which certainly wouldn't be trying to whitewash a bad practice). Summary at

formatting link
They are explaining "investor beware", because there is good logic behind the fine granularity moves that comprise a boom or bust. You can choose to benefit by going either with or against this process (or opt out), but this may be your chance to understand it rather than fobbing it off as irrational psychology. As the authors said, it springs from their frustration at being a value fund during the tech bubble, and even after vindication of their value approach they came to see the need and logic for momentum.

I AM NOT TALKING ABOUT OPPORTUNISTIC SHORT TERM MOVES, as you repeatedly characterize my writeups. Momentum across years and years can be a reasonable part of asset allocation, because at the heart of it is a good fundamental story for some sector (eg. midcaps) or global region that I can commit $ to for that fact alone, but then those slower to recognize it pile on and on to accelerate returns. You may miss the first third of the rise and absorb the first third of the fall, but the middle third is easily in your pocket. This is how I retired early and I don't see how any aware person can fail to use it successfully as at least a bias in asset allocation.

For example how could a Fidelity investor possibly overlook outperformance of their midcap Leveraged Company fund over 5 of the last 6 years

formatting link
^GSPCIn a slow, ladylike fashion it quadrupled while SP500 just gainedabout half, and took over a growing part of my portfolio. Even thedownfall was slow enough to preserve significant gains by the samemomentum principles applied downward. Have done similar things withvarious country funds, etc over long timeframes.

No gambling or short term stuff, with 2 exceptions. Must to be ready to exit fast because crashes can be quick and lengthy. The Japanese bubble and the tech bubble never really recovered afterwards for buy and holders. And more recently I pointed out the NEW need for timing your entrance to avoid losing years of expected returns in the insane fluctuations of a few hours. A blind buy order can and has led to grossly overpaying for a SP500 or 20/30yr tbill position if you don't shield the timing such as with etf limit orders.

Reply to
dumbstruck

Joseph Schumpeter long ago described the economic cycles of "creative destruction". He even predicted the end of capitalism due to the inablity of folks to stomach this rough side effect of healthy entrepreneurship:

formatting link
. Thus there can be market crashes based on fundamentals. I don't think fear by individual players is being ruled out, but the thesis is that a greater (now overwhelming?) influence is being wielded on the market by managers who accelerate trends based on unfortunate but rational expectations. The last line of the executive summary I posted has an unsettling conclusion for the future.

Reply to
dumbstruck

"Momentum" across years and years is correctly known as "normal economic growth."

Shiller among others speaks about the business cycle being some ten years. What you are talking about is short-term performance. Hence many investors care not at all about a track record of a mere six years.

Reply to
honda.lioness

I hope you don't mind if I summarize. Down markets feed on themselves. Up markets feed on themselves.

The reason people will flock to a big sale at Macy's is because they are pretty sure that is the lowest price they will see for awhile. With stocks it's different. Markets uaually overshoot on both the upside and the downside.

======================================= MODERATOR'S COMMENT: Thank you for being succinct.

Reply to
Optimist

A wise man once pointed out that the forest is composed of trees.

PG in 2000 dropped from just under $60 to below $30 in about two months. There was EPS disappointment and mistrust of management. By the end of 2000, it was just under $40, spent all of 2005 above $50, and hit a high in 2007 of $75.18. Today it is $64.

There are many similar stories of earnings disappointments, but the PG story seems appropriate to today's markets.

The fun of doing a model portfolio is that one needn't be concerned with realizing losses to raise cash, or paying taxes on gains, and, it isn't real money to begin with. I'm putting together a model portfolio of ten stocks, and pricing it on Monday. EMR, IR, MSM, FAST, CHRW are sure to be in it. I'm thinking DD, T, CSCO, BP, FISV. And 1000 ODP below $2 for the IRA speculation. (Note - these aren't recommendations, just monopoly money.)

I want to discover for myself whether or not I am rational :-)

Reply to
dapperdobbs

According to the recent working paper listed below, changes in market structure are one of the causes of increased volatility. I have not read the paper yet.

formatting link
97411"Where Have All the Market Makers Gone? Evidence the Markets areBecoming Less Efficient"KURT W. ROTTHOFF, Seton Hall UniversityIn 2006, the NYSE adopted the hybrid market, changing the role ofmarket makers. The added anonymity for traders makes it harder formarket makers to match large continuous order trades, leading to anincrease in volatility and a decrease in efficiency, because lessinformation is contained in the price of a stock at any given time.Using a difference-in-difference estimation, both as an absolute and aconditional comparison, with a variance ratio test, rolling windowtest, event study, and GARCH estimation I find that market volatilityhas increased in hybrid markets, relative to electronic markets as thehybrid market was adopted. Although the hybrid market may increasespeed efficiency, it decreases informational efficiency.

Reply to
beliavsky

BeanSmart website is not affiliated with any of the manufacturers or service providers discussed here. All logos and trade names are the property of their respective owners.