Do Markets “React” to Economic News?
| Peter Klein |
One doesn’t have to be a strict methodological individualist to appreciate that collectives don’t think, act, and choose. Yet one of the standard tropes of financial journalism is the idea that the stock market, like your broker or your Aunt Sally, “reacts” to this or that bit of economic news. “Stocks Soar on Summers Withdrawal,” screams this morning’s Reuters headline. This reporter has some serious powers of discernment: trading Friday “was subdued ahead of the Federal Reserve’s expected reduction of stimulus measures next week.” “In reaction to the withdrawal of Mr. Summers, the dollar slipped to a near four-week low against a basket of currencies.” And: “Further whetting risk appetite were signs of progress in Syria following a Russian-brokered deal aimed at averting United States military action.”
Of course, this is all pure invention on the part of the reporter. Nobody knows for certain why a stock-price average goes up or down. Think about it. The prices of individual stocks reflect expectations of future dividends and future price movements, and they go up and down as new information is revealed about the firm and its competitors. We can never know for certain what makes people buy and sell particular shares but, in the case of an individual firm, we can reasonably infer that shareholders as a group are reacting to new information about the firm. The firm announces quarterly earnings below analysts’ expectations, the share price tends to fall. A competitor announces bankruptcy, the share price tends to rise. Event studies are a popular technique for quantifying investor reactions to news and events related to particular firms.
But the stock market as a whole doesn’t work this way. Stock prices go up and down, and indexes like the S&P 500 and DJIA go up and down according to the performance of their member stocks. Sometimes the average rises, sometimes it falls. Duh. The idea that movements in the index necessarily embody the reaction of the market as a whole to some piece of aggregate economic news reflects a failure to grasp the concept of an average. Of course, it’s always possible that investors’ beliefs about the prospects for particular stocks reflect shared concerns about the economy as a whole. If the government announces an increase in the corporate income tax rate, the prices of many stocks will likely fall. But this applies only to the most obvious cases. Did lots of investors care about Larry Summers’s withdrawal from the Fed race, enough to make them start buying stocks? Who knows? Clearly financial journalists — who are paid to write about such things — care a lot about the next Fed chair. But we have absolutely no idea how much investors care, and no way at all to attribute this morning’s rise in US equity prices to the Summers announcement or any other piece of economic news.
So please, can we stop taking such pronouncements seriously? The stock market is a social institution, an aggregate of individual trades and traders. Let’s stop anthropomorphizing it.