THE ECONOMICS OF MARKET VOLATILITY
Many of the complaints about market volatility are grounded in the be-
lief that the market reacts excessively to changes in news. But how news
should impact the market is so difficult to determine that few can quan-
tify the proper impact of an event on the price of a stock. As a result,
traders often “follow the crowd” and try to predict how other traders
will react when news happens.
Over half a century ago, Keynes illustrated the problem of in-
vestors who try to value stock by economic fundamentals as opposed to
following the crowd:
Investment based on genuine long-term expectation is so difficult today as
to be scarcely practicable. He who attempts it must surely lead much more
laborious days and run greater risk than he who tries to guess better than
the crowd how the crowd will behave; and, given equal intelligence, he
may make more disastrous mistakes.^13
In 1981, Robert Shiller of Yale University devised a method of de-
termining whether stock investors tended to overreact to changes in div-
idends and interest rates, the fundamental building blocks of stock
values.^14 From the examination of historical data, he calculated what the
value of the S&P 500 Index should have been given the subsequent real-
ization of dividends and interest rates. We know what this value is be-
cause, as shown in Chapter 7, stock prices are the present discounted
value of future cash flows.
What he found was that stock prices were far too variable to be ex-
plained merely by the subsequent behavior of dividends and interest
rates. Stock prices appeared to overreact to changes in dividends, failing
to take into account that most of the changes in dividend payouts were
only temporary. For example, investors priced stocks in a recession as if
they expected dividends to go much lower, completely contrary to his-
torical experience.
The word cycleinbusiness cycleimplies that ups in economic activ-
ity will be followed by downs, and vice versa. Since earnings and prof-
its tend to follow the business cycle, they too should behave in a cyclical
manner, returning to some average value over time. Under these cir-CHAPTER 16 Market Volatility 285
(^13) John Maynard Keynes, The General Theory of Employment, Interest, and Money, New York: Harcourt,
Brace & World, 1965, First Harbinger Edition, p. 157. (This book was originally published in 1936 by
Macmillan & Co.)
(^14) Robert Shiller, Market Volatility,Cambridge, Mass.: MIT Press, 1989. The seminal article that
spawned the excess volatility literature was “Do Stock Prices Move Too Much to Be Justified by
Subsequent Changes in Dividends?” American Economic Review, vol. 71 (1981), pp. 421–435.