As good an explanation as any.

Photographer: Gary Burke/Getty Images

Why Stock Prices Fall, Rise or Both

Justin Fox is a Bloomberg View columnist. He was the editorial director of Harvard Business Review and wrote for Time, Fortune and American Banker. He is the author of “The Myth of the Rational Market.”
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Stock prices are collapsing all over the world! At least, that’s what they were doing as I started to write this around 9:30 a.m. today. So exciting! So alarming!

But, uh, what does it mean?

The hard-line answer is, nothing at all. Here’s Nassim Nicholas Taleb’s famous critique from “The Black Swan” of journalists’ perverse need to attach narratives to random market movements (and we won’t take it personally that he uses Bloomberg as an example):

One day in December 2003, when Saddam Hussein was captured, Bloomberg News flashed the following headline at 13:01: U.S. TREASURIES RISE; HUSSEIN CAPTURE MAY NOT CURB TERRORISM.

Whenever there is a market move, the news media feel obligated to give the “reason.” Half an hour later, they had to issue a new headline. As these U.S. Treasury bonds fell in price (they fluctuate all day long, so there was nothing special about that), Bloomberg News had a new reason for the fall: Saddam’s capture (the same Saddam). At 13:31 they issued the next bulletin: U.S. TREASURIES FALL; HUSSEIN CAPTURE BOOSTS ALLURE OF RISKY ASSETS.

Still, when stock prices fall more than 10 percent over a couple of days, it might be something more than just random fluctuation. We should be skeptical of explanations, but that doesn’t mean all of them must always be wrong.

There are two main classes of explanations of market behavior. One sees stock prices as reflecting or even predicting economic reality; the other focuses mainly on the dynamics of markets themselves.

For this morning's market fall, most of the former explanations have to do with China. The Shanghai Stock Exchange Composite index fell 8.5 percent today, bringing the decline since its mid-June peak to almost 38 percent. Investors in China and around the world are worried about the slowing Chinese economy and what that slowdown will mean for global economic growth and Chinese political stability -- and for the prospects of companies, such as Apple, that do a lot of business there.

These are all reasonable fears, but the market’s apparent reaction to them doesn’t add up to any kind of reliable economic forecast. “The stock market has predicted nine of the last five recessions!” economist Paul Samuelson exclaimed in 1966, an analysis that has held up pretty well since. Financial markets have a clear tendency to overshoot, which is why people spend so much time trying to figure out why and how they do so.

These market-based explanations come in many different flavors. Too many different flavors. Some focus on market mechanics -- ever since the 1987 crash, for example, automated-trading-strategies-gone-haywire have been blamed for many market drops, although seemingly not today’s. Many other explanations describe repeating patterns in the movements of stock prices. One well-established pattern, for example, is the tendency of stocks to keep moving in the same direction for a while. Another is the tendency of stocks to perform poorly when they’re expensive relative to dividends or some other fundamental measure, and perform well when they’re cheap. The fascinating thing about these momentum and value effects, as they’re known, is that they describe pretty much opposite phenomena, yet are both backed up by lots of data.

Where does that leave us? Financial adviser and market pundit Josh Brown argued over the weekend that stocks simply have to go down occasionally so they can go up:

The only reason stocks can go up is because they can also go down. It is this risk that keeps investors in check and that keeps people from paying an infinite amount of money for shares in a business.

That’s an appealingly Zen explanation. And at 1:30 p.m., with the Dow Jones Industrial Average up more than 800 points since its low just after trading began this morning (and down 240 points on the day), it also seems pretty convincing. Stock prices fell this morning because if they didn’t, markets wouldn’t work. Thanks, stock prices!

  1. Economist Leonard Mills, in a 1988 paper titled "Can stock prices reliably predict recessions," sourced this quote to a Samuelson column in Newseek dated Sept. 19, 1966.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author on this story:
Justin Fox at justinfox@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net