Financial Markets Wall Street

Trader Tommy Kalikas works on the floor of the New York Stock Exchange, Thursday, Dec. 6, 2018. U.S. stocks tumbled in early trading Thursday following a sell-off in overseas markets. (AP Photo/Richard Drew)

Whenever stock prices rise or fall sharply, there is a natural instinct to ask what happened in the world to suddenly change perception of longer-term investors and shorter-term traders about the prospects for the economy.

After all, economic theory — the so-called efficient market theory — would have us believe that the previous level of stock prices reflected a valuation by millions of sophisticated investors based on all the available data. So the only thing that can explain the new valuation is some new information, in this case prompting all sorts of theories about oil prices or the slowdown in home sales or increased trade tensions that will lower global economic growth.

Or maybe the movement in stock prices, in fact, has very little to do with that. Yes, some of those developments have altered the outlook for the economy and corporate profits. But more likely those are triggering events than the underlying cause of the wild swings in stock prices — matches thrown on a pile of dried wood pile.

The real change is that investors have gone from people (and computers) buying stocks on the expectation that stock prices would continue their steady climb over the last years, to people (and computers) selling stocks because they no longer believe that to be true.

Or put another way, the market is making the transition from people buying stocks because everyone else is buying them to selling stocks because everyone else is selling them. It goes by the name of herd behavior, or momentum investing, and it is the only thing that can explain why, in the 16th century, people were paying as much for a single tulip bulb as they would pay for four fat oxen, eight pigs, two tons of butter or a thousand pounds of cheese.

Did those crazy Dutch really think a tulip bulb was as valuable to them as a thousand pounds of cheese? Of course not. On financial markets, as the great British economist John Maynard Keynes observed, the task of the trader isn’t to calculate the genuine economic value of an asset based on all the information available. Rather, it is more simply to figure out what some other fool will pay for it in the next minute, the next hour, the next day or the next month.

I’m sure that as you are reading this, there are bullish analysts on Wall Street assuring clients and the media that investors are being irrational, that the market is now oversold, that prices have swung too far below economic fundamentals.

But remember that just as the economic fundamentals drive the markets over the long run, markets can drive the economy in the short run. Whether justified or not, falling stock prices caused consumers and businesses to pull back on their spending, which will eventually cause the economy to slow, causing forward-looking stock prices to fall even farther today. In that way, the downward spiral feeds on itself.

Moreover, this vicious cycle is apt to accelerate even more when those who have bought stocks with borrowed money are forced to sell by lenders whose collateral — the stock — is now valued at less than the original loan. In that way too, selling begets more selling.

This is what a bear market looks like: Four steps down, two steps back up, then four more steps down. And just as on the way up, it won’t be over until market sentiment becomes overwhelmingly bearish and the dwindling number of bulls finally throw in the towel. We’re still a long way from that point.

And until we get there, you might want to save yourself the time and aggravation of trying to figure out why the Dow Jones average fell 600 points while you were having lunch. And if we in the business press were being honest, the headline on that story would be the same as it was the day before, and the week before that:

“Stocks fall because stocks fall.”

Steven Pearlstein is a columnist with The Washington Post.