Sun, Aug 19, 2007 - Page 9 News List

Undue sensitivity may be fueling market fears

By Robert Shiller

The sharp drop in the world's stock markets on Aug. 9, after BNP Paribas announced that it would freeze three of its funds, is just one more example of the markets' recent downward instability or asymmetry. That is, the markets have been more vulnerable to sudden large drops than they have been to sudden large increases. Daily stock price changes for the 100-business-day period ending Aug. 3 were unusually negatively skewed in Argentina, Australia, Brazil, Canada, China, France, Germany, India, Japan, Korea, Mexico, the US and the UK.

In the US, for example, the Standard and Poor's 500 index last month recorded six days of declines and only three days of increases amounting to more than 1 percent. In June, the index dropped more than 1 percent on four days, and gained more than 1 percent on two days. Going back further, there was a gigantic one-day drop on Feb. 27 this year, of 3.5 percent, and no sharp rebound.

The Feb. 27 decline began with an 8.8 percent one-day drop in the Shanghai Composite, following news that the Chinese government might tax capital gains more aggressively. This news should have been relevant only to China, but the drop there fueled declines worldwide. For example, the Bovespa in Brazil fell 6.6 percent on Feb. 27, and the BSE 30 in India fell 4 percent the next day. The subsequent recovery was slow and incremental.

In the US, the skew has been so negative only three other times since 1960: at the time of the 6.7 percent drop on May 28, 1962, the record-shattering 20.5 percent plummet on Oct. 19, 1987 and the 6.1 percent decline on Oct. 13, 1989.

Stock markets' unusually negative skew is not inconsistent with booming price growth in recent years. The markets have broken all-time records, come close to doing so, or at least done very well since 2003 ( the case in Japan) by making up for the big drops incrementally, in a succession of smaller increases.

Nor is the negative skew inconsistent with the fact that world stock markets have been relatively quiet for most of this year. With the conspicuous exception of China and the less conspicuous exception of Australia, all have had low standard deviations of daily returns for the 100-business-day period ending Aug. 3 when compared with the norm for the country.

The Feb. 27 drop in US stock prices was only the 31st biggest one-day drop since 1950. But all of the other 30 drops occurred at times when stock prices were much more volatile. Thus, the Feb. 27 drop really stands out, as do other recent one-day drops.

Indeed, one of the big puzzles of the US stock market recently has been low price volatility since around 2004, amid the most volatile earnings growth ever seen. Five-year real earnings growth on the S&P 500 set an all-time record in the period ending in the first quarter of this year, at 192 percent. Before that, between the third quarter of 2000 and the first quarter of 2002, real S&P 500 earnings fell 55 percent -- the biggest-ever decline since the index was created in 1957.

One would think that market prices should be volatile as investors try to absorb what this earnings volatility means. But we have learned time and again that stock markets are driven more by psychology than by reasoning about fundamentals.

Is psychology somehow behind the pervasive negative skew in recent months? Maybe we should ask why the skew is so negative. Should we regard it as just chance, or, when combined with record-high prices, as a symptom of some instability?

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