When people talk about the ongoing tumult in the stock market, they typically blame investors’ lack of information. There’s the uncertainty about the future state of the economy. There’s the confusion about what the government will do next with its ever-changing bailout program. And there’s the mystery of what the mortgage-backed securities clogging bank balance sheets are really worth. Yet, even with all these lurking unknowns, investors have far more information today than ever before. Your ordinary day trader, if any of those still exist, enjoys far greater access to economic and market data than men like J. P. Morgan did when they were running Wall Street. But this information isn’t necessarily making investors, or the market, any smarter. In fact, what may be driving the market crazy of late is that it knows too much.
The problem isn’t so much the never-ending stream of surveys, studies, and statistics—retail sales, housing prices, consumer confidence, unemployment claims, and so on. These numbers, though of varying accuracy and usefulness, at least offer a picture of what’s happening in the economy—which is, in the long run, the fundamental driver of stock prices. The real problem is that investors are also deluged with another data stream; namely, all the trading information from the world’s many markets, which gives them a constant, noisy, and often misleading impression of what other investors are thinking.
Investors have always paid attention to what other investors were doing, of course, but currently they’re assailed by a high-volume clang of market bellwethers twenty-four hours a day. After the stock market closes in the U.S., for instance, American investors begin to look to the S. & P. futures market to figure out where prices might be headed. Then they turn to foreign markets, first in Asia and then in Europe, which often set the tone for how the U.S. stock market will open. And less well-known markets have lately had a powerful effect on how stocks behave. The Chicago Board Options Exchange has an influential index, the VIX, which is often called the “fear index,” because it measures investors’ expectations of market volatility. The credit-default-swap market, too, has become increasingly important in shaping the stock market. Credit-default swaps are essentially insurance bought against the possibility that a company will default. And, these days, if the price of a company’s credit-default swaps rises (meaning that its chance of default is thought to be higher), its stock price will often fall.
These markets and indexes are valuable as a way to help investors hedge risk. But, in an environment of profound uncertainty, investors have a natural if troubling tendency to turn to them as horoscopes, particularly since they now get so much attention in the business press: you have only to turn on CNBC or go online to find that the Japanese market is cratering or the VIX index soaring. The result is to draw investors away from the grind of analyzing corporate performance and economic fundamentals, and to encourage pure speculation—investing as an exercise in anticipating what other investors will do. Meanwhile, traders in other markets are looking to our stock market for guidance—Nikkei traders usually react positively when the Dow rises—or, like VIX and futures traders, are overtly trying to forecast what our stock market will do. Investors find themselves trapped in a mirror maze, like the gunslingers in “The Lady from Shanghai.”
All this market-watching rarely has good effects. It can easily lead to contagion, where selling in one market triggers selling in the next. It also creates interesting opportunities for manipulation. Earlier this year, when financial firms were under siege from short sellers, there was conjecture that people were buying credit-default-swap protection on companies they had shorted. That would have had the effect of driving up those companies’ C.D.S. prices, which would make it look as if the C.D.S. market were seriously concerned that the companies might go bankrupt—which, in turn, would drive their stock prices down, enriching the short sellers. If short sellers weren’t doing this, they were passing up free money.
Even if these ancillary markets aren’t being gamed, the attention paid to them is out of all proportion to their informational worth. Because they are small relative to the elephantine U.S. stock and bond markets, it doesn’t take a lot of money to move them significantly, and since they have low margin requirements, speculators can have a big impact on prices while putting up only a little cash. Credit-default-swap contracts, similarly, are generally not that expensive, so fairly small investments can move prices noticeably. When U.S. stock-market investors take their cues from these other markets, the tail is wagging the elephant.
Markets work best when investors are thinking for themselves, and tend to go awry when the obsession with what everyone else is doing becomes a dominant concern. Maybe what investors really need is to periodically take a market-information vacation. On that count, the market’s recent performance may offer a small glimmer of hope: the other week, the foreign and futures markets signalled that a colossal U.S. selloff was coming, but, when the stock market opened, investors were relatively restrained in their selling. These days, a broken mirror may bring good luck.
