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Half-Blind Bus Drivers

What moves the markets? An answer to this question is offered after every daily news report on the status of the Dow Jones Industrial Average. We are told the market moved as it did due to, “Jitters over unemployment figures”, “anticipation of a Fed rate cut”, “profit-taking”, “surprising earnings from Company X”. Sometimes they can’t invent a reason and say the markets, “shrugged off” whatever was supposed to be important.

There is an ocassional kernel of truth in these explanations. Interest rates, for example, affect nearly every business transaction. So when the Fed changes rates, it will likely move the market. Or more accurately, will move most components of the market.

The interest rate example offers insight toward what really moves the market. The Fed changes interest rates only at set times, and they usually signal their moves in advance. The broad market reacts to the signal (or an interpretation of the signal) in advance of the actual rate change. When the Fed makes its move official, traders react. If prices don’t move much, it may seem like no reaction at all, but that lack of apparent reaction probably means the Fed did what was expected. The influence of the Fed had already been priced in.

When the Fed changes its policy more or less than expected, we hear it from the news readers. “Fed lowers rates more than expected; market surges”, or, “Fed holds the line, buyers head for the exits”, are the sort of headlines offered.

This same pattern holds for other somewhat-predictable events. Major company earnings reports, hurricanes which threaten energy supplies, and the release of economic statistics on trade and employment all offer opportunities for analysts and stock traders to anticipate the actual outcome of the event, and to guess how it might effect any company’s sales and earnings.

Players in the stock and bond markets are forward-looking. So, what moves the market? Expectations.

Investors want to move their capital from lower-earning companies to higher-earning companies. One does not get a piece of last year’s earnings. That benefit went to whoever held shares last year. To participate in the gain of a company doing well, an investor has to guess right. One must “buy low”. And “low” is meaningful only in the future context. Film camera companies may be trading at a low price today compared to their past average, but as digital photography continues expanding, film companies will only go lower.

Playing on the photography example, how would one shift capital assets? Should one buy digital camera companies? Or companies that make chips and sensors that the camera companies buy? Or maybe some company which has a promising new way to share digital photos? Which is in line to win a huge Defense contract? Or which will see their costs rise due to some labor or environmental legislation?

Every company in every sector of the economy is subject to this kind of guessing game. This is why it seems silly to say the market moved today due to “jitters”, or that it “shrugged”. The process of evaluating and expecting is relentless. There is money to be made by exploring deeper detail, and digging out better information.

The real economy is a vast web. The companies which comprise the market are intertwined in obvious and not-obvious ways. The share price of any given company is an abstraction of the best guesses about that company’s future. The Dow Jones Industrial Average is just that, an average of the abstracted guesses on the future worth of 30 companies out of 7000+ plus actively traded.

The web is all too complex for a simple headline. Or a simple assertion about cause and effect. Politically, few single policies have the wide impact of a Fed rate change. A regime of policies may begin to have influence.

Stepping back to the camera example, a combination of a large Defense contract, mid- to long-term changes in labor cost due to legislation, and environmental legislation raising costs of chip suppliers might all play into estimates—informed guesses—about a digital camera company. Will an overseas company do better, not subject to the same laws? Or will Defense requirements for secure supply limit the value of an overseas company? Or is there talk of changing tariffs on semiconductors? Will a Congressperson earmark some pork for a ultimately-doomed film factory in his district?

The hand of government tugs at most of the threads in our economic web. The state is a player in the market.

In fact, government is a huge player. Probably the only player who can manipulate the broad market in any significant way.It is certainly the only player with a stated goal to manipulate the market. The Fed has this power under a single authority. Most of the rest of government power is so widely distributed that it is easy to overlook, or to dismiss, the impact of any single agency or bureau. Yet, government pulls strings, actively trying to reshape the economic web.

Trouble is, the policy makers have to go about all the same guessing as investors and traders. Government isn’t interested in changing the past. In a democratic system, votes are in the future.

Politicians and policymakers are not, however, on the same footing as investors. Government can’t be wiped out. There’s really no catastrophic penalty for a policymaker who guesses wrong. And for politicians, economics is almost never part of their education. They’re lawyers and public administrators. Few who rise to the upper echelons have run a business. Politics has become a lifetime career.

Thus, the people who have the greatest influence on the economy have different goals and different experience from those who actually are the economy. We have half-blind bus drivers poking at the control panel of a space shuttle. Perhaps well-intentioned, but doomed to unintended consequences.


As an addendum, this post was inspired by something at Naked Capitalism. It seems that switching the bailout from big banks to anybody who makes loans is causing problems. The policy change is forcing a huge collection of guesses to be re-guessed. This contradicts the bailout’s purpose of stabilizing financial markets and the general economy.

As we have noted before, intervening in a tightly-coupled system like a nuclear reactor or our financial system, as Richard Bookstaber said, often makes matters worse (the system is so tightly integrated that any move will create diffcult to predict and often destabilizing knock-on effects. We have discussed these unintended consequences in the past.

One is that, particularly with stock prices low and trading in equity and other markets thin, forced selling by hedge funds is even more disruptive than at normal times. And with hedge funds deleveraging for a whole bunch of reasons (margin calls, investor redemptions, tougher standards at prime brokers), distress in one market leads to margin calls, which can lead hedge funds to sell not the asset subject to the margin call (if that market is tanking, you will get a terrible price and would make any similar positions worse) but one that is less impaired, which could be in a completely different market.