Day To Day, Stocks Go Up And Down Mostly For Irrational Reasons – Billions Change Hands Not On Account Of Facts; But Because Of Mood Swings

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By Paolo von Schirach

September 30, 2012

WASHINGTON – Supposedly stock markets are the best vehicles to provide rational capital allocation to promising publicly traded enterprises. Well, it may come to you as a shock, but it is not so. There can be millions of better of examples to illustrate this, but let me pick just this one not because it is egregious but because it is recent.

Manufacturing data blip

After several months of disappointing decline, the US manufacturing index went up, just a little bit. As an expert put it, numerically this one month advance is insignificant; but psychologically it boosted market sentiment. And so, in early trading, the Dow Jones shot up 150 points, a substantial advance.

Which is to say that a small bit of quasi-news can move billions of dollars in a matter of hours of even minutes, this way changing significantly the valuation of major companies. And all this happens because traders had an emotional reaction to the news. Irrespective of the substantive value of the new information, it made them “feel good” and so they went to Wall Street and bought stocks. And we call this behavior “rational allocation of scarce resources“? This is real money, folks.

Bernanke provided a sobering picture

But how about reacting to real news? On the same day of this manufacturing data high, Ben Bernanke, Chairman of the Federal Reserve, speaking in Indiana provided a sobering picture of the US economy. No, we are not headed towards another recession, Bernanke said. However, we have a dismal rate of growth (under 2%) that cannot possibly help in mopping up our stubbornly high unemployment rate. What is worse, he continued, there are just too many long-term unemployed Americans. The longer people have been out of job, the harder it is to get back into the labor market. Which is to say, our hard times are far from over.

Now, what should a rational person do? Be conservative on the basis of a relatively pessimistic outlook presented by a leading policy-maker, or be daring on the basis on a one month small blip, affecting just one index?

Irrational behavior

In the long run, stock valuations may provide a true reflection of real economic value. But on a day-to-day basis they are mostly a reflection of irrational mood swings: enthusiasm or fear, (in some cases panic). So much for a system designed to provide a rational allocation of scarce resources.

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