Some Observations on Stock Market Volatility
Over the past decade, global capital markets have experienced one of the most volatile periods in their entire history. For example, since the millennium, the index of Britain's highest valued companies, the FT-SE 100 (Footsie) has often moved up and down by more than 100 points in a single day, fuelled by the extreme price fluctuations of risky internet or technology shares, the changing profitability of blue-chip companies at the expense of emerging markets, rising oil and commodity prices, interest rates, global financial crises, increased geo-political instability, military conflict, natural disasters and even nuclear fallout. Consequently, conventional methods of assessing stock market performance, premised on efficiency and stability, as well as the models upon which they are based, are now being seriously questioned by a new generation of academics and professional analysts.
So, where do we go from here?
Post-modern theorists with their cutting-edge mathematical expositions of speculative bubbles, catastrophe theory and market incoherence, believe that markets have a memory. They take a non-linear view of society and dispense with the assumption that we can maximise anything. Unfortunately, their models are not yet sufficiently refined to provide simple guidance for many market participants (notably private investors) in their quest for greater wealth.
Irrespective of its mathematical complexity, the root cause of the problem is that however you model it, financial analysis is not an exact physical science but an imprecise social science. And history tells us that the theories upon which it is based may even be "bad" science.
All economic decisions are characterised by hypothetical human behaviour in a real world of uncertainty that by definition is unquantifiable. Thus, theoretical financial strategies may be logically conceived but are inevitably based on objectives underpinned by simplifying assumptions that rationalise the complex world we inhabit. At best they may support our model's conclusions. But at worst they may invalidate our analysis.
As long ago as 1841, Charles Mackay's classic text "Extraordinary Delusions and the Madness of Crowds (still in print) offered a plausible behavioral explanation for volatile and irrational financial market movements in terms of "crowd behaviour". He asserted that:
It is a natural human tendency to feel comfortable in a group and only make a personal decision, which may even be irrational, after you have observed a trend.
The late Charles P. Kindleberger's classic twentieth century work "Manias, Panics and Crashes: A History of Financial Crises" first published in 1978 provides further insight into Mackay's "theory of crowds" As a study of frequent irrational investor behaviour in sophisticated markets, the book became essential reading in the aftermath of the 1987 global crash. Now in its sixth edition (2011) revised and fully expanded by Robert Aliber to include analyses of the causes, consequences and policy responses to the 2007 financial crisis, it is even more relevant today.
Kindleberger and Aliber argue that every financial crisis from tulip mania onwards has followed a similar pattern. Speculation is always coupled with an economic boom that rides on new profit opportunities created by some major exogenous factor, like the end of a war (1945 say) a change in economic policy (stock market de-regulation) a revolutionary invention (like the computer) political tension (the Middle East) or a natural disaster (Japan). Fuelled by cheap money and credit facilities (note the interest rate cuts that financed American post-Gulf war exuberance and the internet boom of the 1990s) prices and borrowing rise dramatically. At some stage a few insiders decide to sell their investments and reap the profits. Prices initially level off, but a period of market volatility ensues as more investors sell to even bigger fools. This stage of the cycle features financial distress, characterised by financial scandals, bankruptcies and balance of payment deficits, as interest rates rise and the market withdraws from financial securities into cash. The process tends to degenerate into panic selling that may result in what Kindleberger terms "revulsion".
At this point, disillusioned investors refuse to participate in the market at all and prices fall to irrationally low levels. The key question then, is whether prices are low enough to tempt even skeptics back into the market.
Robert Shiller, in his recent edition of "Irrational Exuberance" (2005) developed Kindleberger's analysis by citing investors who act in unison but not necessarily rationally. Market sentiment gains a popular momentum, unsubstantiated by any underlying corporate profitability, intrinsic asset values, or significant economic events, which are impossible to unscramble as more individuals wait to sell or buy at a certain price. When some psychological barrier is breached, price movements in either direction can be triggered and a crash or rally may ensue. As Shiller concludes, if Wall Street is a place to avoid, the question we must ask ourselves is how can market participants (private individuals, or companies and financial institutions who act on their behalf) satisfy their investment criteria in a post-modern world.
Fortunately, traditional finance theory can still throw a lifeline. Human action, reaction, or inaction may be reinforced by habit and individual investors may only become interested in a market trend (up or down) when it has run its course and a crash or rally occurs. But in between time, when markets are reasonably stable, bullish or bearish, there are plausible strategies for individuals and financial institutions that continually trade shares, as well as companies considering either a stock market listing for the first time, or periodic predatory takeovers.
All are based on today's news, current events, historical data contained in published accounts, the financial press, as well as the internet and other media that relay financial service, analyst and broker reports. And as we shall discover, until new models are sufficiently refined to justify their real world application, the common denominator that drives this information overload upon which investment strategies are based is still conventional share price theory.
If you have previously downloaded other studies by the author in his bookboon series, then before we continue you ought to supplement this Introduction by re-reading the more detailed critiques of Fisher's Theorem, the development of Finance Theory and the Efficient Market Hypothesis (EMH) contained in any of the following chapters.
Strategic Financial Management: Exercises (SFME), Chapter One (2009).
Portfolio Theory and Financial Analyses (PTFA), Chapter One (2010).
Portfolio Theory and Investment Analysis (PTIA), Chapter One (2010).
These will not only test your understanding so far, but also provide a healthy skepticism for the theory of modern finance that underpins the remainder of this text.
If new to bookboon then I recommend you at least download SFME and pay particular attention to Exercise 1.1.The exercise (plus solution) is logically presented as a guide to further study and easy to follow.
Throughout the remainder of this book, each chapter's exercises and equations also follow the same structure as all the author's other texts. So, you should be able to complement, reinforce and test your theoretical knowledge of the practicalities of corporate valuation and takeover at your own pace.