Wednesday, July 16, 2008

Death by illogically exuberant consensus in the markets

Many of us over the last few days have seen prices for a barrel of oil see-sawing between 140 and 130 dollars a barrel and Fannie and Freddie Mac stocks taking wild rides in the stock market rollercoaster. Not to mention the frequent up and downswings of the DOW above and below the 11,000 mark. It often leads one to think that we may be overreacting to the information glut which may be completely useless half the time. In fact, I heard a joke on NPR yesterday telling us that the price of oil fell by nine dollars because there were NO bellicose pronouncements by the leader of Venezuela who shakes his sabers every couple of days rattling the world oil markets. Of course, not to be outdone, another take on the oil prices per barrel dropping was attributed to the clarion call of the current President of the United States exhorting the congress to pass legislation to drill for little known deposits of oil in the continental United States. Maybe the reason for such wild rides in prices could be that we have too much information on our hands and little know on how best to use and process the same. What if we suddenly stopped the flow of information to the markets and instead fed the markets global news at the end of every day - in a capsule format. Or, lock up the traders in the pit of the stock exchange, let them mull over the analysts reports, mull over company quarterlies and then figure out the best positions on take on any stock or fixed income instrument after a proper analysis. Would this be a good idea or just another crazy socialist pitch to controlling the markets? Apparently it does not seem like a crazy idea if one extrapolates from a study done by a Harvard psychologist.

In a Harvard study by psychologist Paul Andreassen, two groups of investors were given information necessary to value a stock and then asked to trade it. The only difference was that one group received frequent news about every development at the company, whereas the other received only quarterly earnings releases. The result? The latter group traded far less and ended up with twice the profits of those fed frequent news. (from here)

If one takes the sad decline of Freddie Mac and Fannie Mae, I think a comparatively small number of people might have responded to bad news in the mortgage market by selling their holdings thus causing the prices to initially fall. This fall in prices might have led others to follow the initial herd and additional selling ensued. Add to the mix the news media huffing and puffing to report on a minute by minute basis reinforcing and goading peripheral observers to sell their small holdings leading to a 'death by illogical consensus' for the stock that thus gets clobbered.

Then there are stocks that tend to act as 'stunners' grabbing so much of one's attention that focus on anything else is seems impossible. Kind of like billboards on Times Square.

A study by professors Brad Barber (UC Davis) and Terrance Odean (UC Berkeley) found that individual investors disproportionately buy “attention-grabbing” stocks, which they defined as those heavily in the news, those experiencing high, abnormal trading volume or those having just had extreme one-day returns. The authors argued that investors behave this way because of the difficulty in winnowing out good investment ideas – focusing on companies making the news helps limit the choices
.(from here)

This does not go to say that one pays no attention to the news and one starts to sit down and parse financial statements and analyst fine print before making a decision to go wild with their holdings (and I think it will be stupid to do so)... On the contrary, what this points to is a sad fact of our lives - having access to more information than ever before and not knowing what to do with - worse - being actually harmed by the very information that surges to us from all sides. Corrective steps will include a more pragmatic approach to the market events that include letting the people who want to ride their ill advised Pamplonas complete their bloody course and then betting ones options calmly over the resulting carcasses of ill thought decisions. As always, the calm after the initial storm helps.

Carl Rungius (1969 - 1959), 'Alaskan Brown Bear - Out of the Shadows', oil on canvas, 60" X 75"


Ashok said...

I think the information or financial porn is churned out so wall street can still stay in business.

"The more you trade, the less you keep." - Benjamin Graham

Sunil said...

I agree, Ashok.