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Inside the Black Box: A Roller Coaster

News

The Dow Jones plunged 171 points Friday (March. 8, 1996) on the news that suggested inflation was heating up. It gained back 110 points on Monday, and on Tuesday it plunged nearly 100 points but rebounded to close up 2.98 points at 5,583.89.

Let’s look at how the "black box" works:

Step 1: Observed Input

Investors observe new available information. In this illustration I will use the employment numbers that were announced last Friday.

Step 2: Individual Investors Form Expectations

Individual investors form their own "view" of the implication of the news on the stock market, i.e., form their own estimate of the stock market’s expected future cash-flows and the associated risk.

Step 3: Black Box

Based on their estimates above, if an investor concludes that the new information is not favorable for the stock market, she would sell her shares. On the other hand, she would be buying if she reached the opposite conclusion.

Thus, those investors who have revised their expectations as a result of the new information would go to the market to trade their stocks with investors who have the opposite "view" of expected cash-flows and the associated risk.

Step 4: Observed Market’s Reaction

What we observe is the aggregate outcome of all those investors’ expectations as manifested in new stock prices.

Step 5: Concluding Inference

If the stock prices end up higher, then you can infer (conclude) that the market--the average investor--must have thought that the new information was good for the market; the opposite conclusion implies otherwise.

Step 6: Price as a Signal

The new price that emerged might itself trigger this process anew, i.e., we might end up at Step 1 again. The process will start again when new information becomes available.

Why Call It A Blackbox?

I call this process a "blackbox" because we don’t know why or how investors form new expectations. All we observe is the outcome of their expectations as measured in terms of stock prices. Thus, given the observed impact on prices, all we can do is infer what the average investor’s reaction to the news must have been.

So What Can We Infer From This Latest Roller Coaster?

On Friday, the average investor must have interpreted the news as "bad" for the stock market, while on Monday it was not so bad, and bad again and not bad on the same day Tuesday. It seems that the average investor is uncertain about the impact of this news on the stock market.

What must have I implicitly assumed about new information?

The analysis assumes "everything else held constant" that is, there was no other new information that investors had to react to. This was actually true, which makes the above analysis more robust.

What about the implications on the EMH?

This is not evidence against the EMH. There is not evidence that an investor would have been able to exploit the price movements to generate excess profits. Sure, some investors made a lot of money, while others lost. However, for the market to be inefficient you need a strategy that can systematically yield higher returns and not just make money based on lucky speculation. Actually, the market opened lower on Monday before mustering the 110-point gain. Put differently, increased volatility in stock prices does not necessarily suggest an inefficient market.

By Alex Tajirian