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The sharp drop in the world's stock markets on
August 9, 2007, after BNP Paribas announced that it
would freeze three of its funds, is just one more
example of the markets' recent downward instability
or asymmetry. That is, the markets have been more
vulnerable to sudden large drops than they have been
to sudden large increases.
Daily stock price changes for the 100-business-day
period ending August 3 were unusually negatively
skewed in Argentina, Australia, Brazil, Canada,
China, France, Germany, India, Japan, Korea, Mexico,
the United States (US) and the United Kingdom (UK).
In the US, for example, the Standard & Poor's 500
index in July recorded six days of declines and only
three days of increases amounting to more than one
per cent. In June, the index dropped more than one
per cent on four days, and gained more than one per
cent on two days. Going back further, there was a
gigantic one-day drop on February 27, 2007, of
3.5pc, and no sharp rebound.
The February 27 decline began with an 8.8pc one-day
drop in the Shanghai Composite, following news that
the Chinese government might tax capital gains more
aggressively. This news should have been relevant
only to China, but the drop there fuelled declines
worldwide. For example, the Bovespa in Brazil fell
6.6pc on February 27, and the BSE 30 in India fell
four per cent the next day. The subsequent recovery
was slow and incremental.
In the US, the skew has been so negative only three
other times since 1960: at the time of the 6.7pc
drop on May 28, 1962, the record-shattering 20.5pc
plummet on October 19, 1987, and the 6.1pc decline
on October 13, 1989.
Stock markets' unusually negative skew is not
inconsistent with booming price growth in recent
years. The markets have broken all-time records,
come close to doing so, or at least done very well
since 2003 (the case in Japan) by making up for the
big drops incrementally, in a succession of smaller
increases.
Nor is the negative skew inconsistent with the fact
that world stock markets have been relatively quiet
for most of this year. With the conspicuous
exception of China and the less conspicuous
exception of Australia, all have had low standard
deviations of daily returns for the 100-business-day
period ending August 3 when compared with the norm
for the country.
The February 27 drop in US stock prices was only the
31st biggest one-day drop since 1950. But all of the
other 30 drops occurred at times when stock prices
were much more volatile. Thus, the February 27th
drop really stands out, as do other recent one-day
drops.
Indeed, one of the big puzzles of the US stock
market recently has been low price volatility since
around 2004, amid the most volatile earnings growth
ever seen. Five-year real earnings growth on the S&P
500 set an all-time record in the period ending in
the first quarter of 2007, at 192pc. Before that,
between the third quarter of 2000 and the first
quarter of 2002, real S&P 500 earnings fell 55pc
"the biggest-ever decline" since the index was
created in 1957.
One would think that market prices should be
volatile as investors try to absorb what this
earnings volatility means. But we have learned time
and again that stock markets are driven more by
psychology than by reasoning about fundamentals.
Is psychology somehow behind the pervasive negative
skew in recent months?
Maybe we should ask why the skew is so negative.
Should we regard it as just chance, or, when
combined with record-high prices, as a symptom of
some instability?
The adage in the bull market of the 1920's was "one
step down, two steps up, again and again". The
updated adage for the recent bull market is "one big
step down, then three little steps up, again and
again," so far at least. No one is looking for a
sudden surge, and volatility is reduced by the
absence of sharp up-movements.
But big negative returns have an unfortunate
psychological impact on markets. People still talk
about October 28, 1929, or October 19, 1987. Big
drops get their attention, and this primes some
people to be attentive for them in the future, and
to be ready to sell if another one comes.
In fact, willingness to support the market after a
sudden drop may be declining. The "buy-on-dips stock
market confidence index" that we compile at the Yale
School of Management has been falling gradually
since 2001, and has fallen especially far lately.
The index is the share of people who answered
"increase" to the question, "If the Dow dropped
three per cent tomorrow, I would guess that the day
after tomorrow the Dow would: Increase? Decrease?
Stay the Same".
In 2001, 72pc of institutional investors and 74pc of
individual investors chose "increase". By May 2007,
only 48pc of institutional investors and 59pc of
individual investors chose "increase".
Perhaps the buy-on-dips confidence index has slipped
lately because of negative news concerning credit
markets, notably the US sub-prime mortgage market,
which has increased anxiety about the fundamental
soundness of the economy.
But something more may be at work. Everyone knows
that markets have been booming, and everyone knows
that other people know that a correction is always a
possibility. So there may be an underlying
sensitivity to price drops, which could fuel a
succession of downward price changes, amplifying
public concerns about problems in the economy and
heralding a profound change in investor sentiment.
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