Sunday, July 15, 2007

Why the Stock Market Bounces Around

On Thursday, July 12, 2007, the stock reached a record high, with the Dow Jones Industrial Average rising 283.86 points to close at 13,861.73. What the heck happened? News reports attributed the market jump to positive news about retail sales and the announcement of a planned acquisition of a Canadian aluminum company, Alcan Inc. But were those stories really the cause? People still flock to the malls and someone wants to buy an aluminum company? Or was there more to it?

The stock market is the aggregation of the interactions of many thousands of persons and institutions. They buy and sell stocks, options, ETFs and other investments. All of their transactions, put together, create the image of beehive activity that you get from the financial news on cable TV. But the markets today are dominated by large, institutional investors--hedge funds, mutual funds, investment banks, pension funds, insurance companies, and the like. These players are so big that sometimes one of them can alone have a noticeable impact on the market.

For example, let's look at an enforcement case brought by the SEC in 1996 against an investment fund management firm called Tudor Investment Corporation. The SEC's order in this case told the following story. Tudor Investment had a trading strategy that involved selling a large quantity of stocks included in the Dow Jones Industrial Average. It believed that on a particular day, March 16, 1994, the prices of the Dow Jones Industrial Average stocks were going to swing upwards at the end of the trading day (i.e., 4:00 p.m. Eastern Time). Beginning at approximately 3:39 p.m., Tudor Investment traders began to sell, in the hope of profiting from the expected upswing in prices. They managed to sell over 1 million shares of stock in the last 21 minutes of the trading day. In the last 4 minutes of the trading day (i.e., from 3:56 p.m. to 4:00 p.m.), the Dow Jones Industrial Average dropped 16.45 points (or about 0.43%) of the index's value at that time. The SEC asserted that Tudor Management's sales toward the end of the trading day "were a significant factor" in the 16.45 point drop.

The SEC charged that Tudor Investment violated the short sale rule, a regulation that limits the circumstances in which a person or institution can sell stock they don't own. (As odd as it may sound, you are allowed in the stock market to sell stock you don't own--it's a way of betting that the stock will drop in value.) Tudor Investment settled the case without admitting or denying the SEC's charges. (That's another oddity of the stock markets--legal settlements where a party neither admits nor denies breaking the rules.) If you want to read the SEC's order in this case, here's the link:

The important point here is that a single player in the market "was a significant factor" in a noticeable market move. Taking the July 12, 2007 closing value of the Dow Jones Industrial Average, 13,861.73, a 0.43% change would be about 59 points. If you could apply the events of March 16, 1994 to today's market, a single player might be able to move the Dow by 59 points. Today, it would probably take much more than the purchase or sale of 1 million shares. But, these days, big institutional investors command portfolios containing much more than 1 million shares of stock.

The stock market has undercurrents and riptides that are difficult or impossible to see from the outside. If you're an active market player, you might feel their tug. But you'd probably have a hard time figuring out where they are coming from or where they are going. Only in those unusual situations where the SEC or another regulator finds something to frown about will information surface publicly as it did in the Tudor Investment case. The rest of the time, you probably won't know what happened, and will probably never learn. Retail sales and the Alcan acquisition probably did help to push the market up on July 12, 2007. But were there other factors? Did some foreign investors, anticipating interest rate increases in their home countries, decide to shift money into the U.S. market? Did some large institutional investors decide to reallocate their increasing exposures to rising foreign markets and move assets into the U.S. markets? Did some institutional investors losing money in subprime mortgage-backed CDOs decide to cut their losses and shift their money into stocks? These are only a few of the possibilities.

So how can you get a read on the markets? One way to separate the wheat from the chaff is to look at market movements from week to week. Pick one day a week--Friday is a good choice--and look at the closing prices on that day for each week. You'll see that week-to-week movements of the market are much smoother than day-to-day movements. By looking at the market on a weekly basis, you sift out some of the riptides and undercurrents caused by large investors, and can get a better handle on overall market trends.

Another lesson here is that day trading stocks, and other short term trading, is very dangerous for the individual investor. If you try to profit from one day's news about retail sales or aluminum companies, you're playing bumper cars where you have a subcompact and the big investors are driving tractor trailers. They can easily overrun you and never notice. You can't predict where your stocks will go short term because you never know when a big tractor trailer will barrel over your trading strategy. Pick an investment strategy that smooths out the bumps in the road. Invest for the long term, on a diversified basis.

Crime News: If you're confronted by a robber, try offering a glass of wine and a hug.

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