Cause and Effect

Jul 2009 //
Behavioral Finance

The 2007 – 09 declines in the economy and the stock market may seem to be completely related.  Although the recession has been one of the worst, the decline in the stock market was far greater than we can logically attribute to a temporarily weaker economy.  Indeed, throughout history it has been normal for stock markets to overreact to economic developments—because people frequently overreact.  For example, between 1995 and 1998, net inflows into technology stock mutual funds averaged maybe $0.1 billion per month.  However, in 1999, tech stock mutual fund inflows grew to $1 billion monthly—and then they grew to $2 billion and eventually to over $5 billion.  In the December 1999 – February 2000 period, tech fund inflows jumped to an amazing $10 billion per month—100 times the 1995 – 98 levels.  Is it any surprise that tech stock prices skyrocketed in 1999 and early 2000?  More recently, in late 2008 general equity fund net outflows reached their greatest levels in history—and that’s one important reason why stock prices plunged late last year.  As history makes quite clear, dramatic swings in investor confidence—apart from the much smaller swings in GDP—primarily cause the volatility in markets that investors mistakenly attribute to recessions, inflation, deflation, political meddling and other secondary factors.