When To Pay Attention To The Stock Market (And When To Ignore It)

By
from FiveThirtyEight

After a long period of quiet, the markets are once again taking investors on a wild ride. The Dow Jones Industrial Average fell 173 points on Wednesday, the fourth big drop in five trading days. The Dow was down a more modest 25 points on Thursday, but only after another day of gyrations, both up and down. Meanwhile, oil prices are way down, U.S. treasury yields briefly fell below 2 percent and a key measure of market volatility recently hit at a two-year high.

We don’t write much about financial markets here at FiveThirtyEight. That’s intentional. Markets are important, but there’s already lots of good coverage out there. There’s also lots of really bad coverage — the deluge of minute-by-minute market data makes it incredibly tempting to see signals in what is really just noise. We don’t follow every up and down of the market because, unless you’re a trader, it just doesn’t matter.

But there are times when even non-traders should pay attention to the markets, either because they’re so bad they’re affecting the rest of the economy (think Lehman Brothers in 2008), or because they’resending a signal about bad news around the corner. How do you know when to do that? You can’t, at least not perfectly. But by following a few simple guidelines, you can avoid getting caught up in the hype and stay focused on what really matters.

Ignore the day-to-day moves: Wednesday was the 26th time this year that the Dow rose or fell by at least 1 percent. It happened 24 times in 2013 and 39 times in 2012. In other words, big swings in the market happen dozens of times a year — and usually mean absolutely nothing. Economist Eugene Fama won a Nobel Prize for demonstrating that the stock market is a “random walk” — its short-term moves don’t reveal anything about the long-term trend.

Even if you’re determined to search for meaning in daily stock moves, by the way, the Dow is the wrong place to look. The Dow is an unweighted index of 30 big-company stocks, such as Microsoft, General Electric and Goldman Sachs — hardly representative of corporate America, let alone the overall economy. Better to focus on a broader index like the S&P 500 or, better still, several different indexes.

And definitely ignore the day-to-day explanations: News stories often say things like “stocks rose on better-than-expected jobs numbers” or “stocks fell on fears of a slowdown in China.” Those statements are usually little more than educated guesses — and sometimes not even that educated. Traders don’t file explanations with their buy or sell orders. Sometimes, there’s clear evidence for why the market moved — when markets all change direction immediately after a big economic report, for example, or when oil company stocks all move together along with energy prices. But remember that investors mostly aren’t trading “the stock market” — they’re buying and selling shares in specific companies, often for reasons that have nothing to do with the broader economy. (Josh Barro of The New York Times had a fun piece Thursday on a particularly meaningless “explanation,” namely “profit-taking.”)

One surefire sign that you should ignore most of these supposed explanations: The same piece of news often gets used to explain stock-price moves in both directions. For example, good economic news should, all things equal, push the market up. But in recent years, investors have been concerned that the improving economy will lead the Federal Reserve to pull back on its efforts to stimulate growth, which would likely be bad for stocks. Any explanation that can work equally well for totally conflicting outcomes isn’t an explanation at all.

Look beyond U.S. stocks: One hint that the recent volatility is worth your attention is that it hasn’t been confined to the stock market, or to the United States. It has hit energy, international markets, government bonds and currencies, too. And the various moves generally make sense together: Falling oil prices and rising Greek bond yields could both reflect investor fears about global growth; the money flowing into U.S. treasuries likewise suggests investors are looking for a safe haven. Just because investors are acting in a coherent fashion doesn’t mean they’re right. But it at least suggests they see something larger to pay attention to.

Keep it in context: The S&P 500 Index is down about 7 percent from the record high it set last month. That isn’t even enough to qualify as a “correction” (usually defined as a drop of at least 10 percent), let alone a crash. If on the last day of 2013 you invested $1,000 in an index fund that tracks the S&P 500, it’s worth $1,008 today — essentially flat. That isn’t the kind of return you want to see over an extended period, but it’s no disaster, either.

It’s also worth keeping the whole market in context. According to the Survey of Consumer Finances, just under half of U.S. households own any stock at all, directly or indirectly; exclude retirement accounts like 401(k)s and the figure falls even more. Americans who own stocks tend to be richer, so if they react to the market downturn by reducing their spending, it could hurt the overall consumer economy. But economic research has called into question the significance of the so-called wealth effect, in which consumers respond to market moves by changing their spending behavior. From a macroeconomic perspective, the stock market just isn’t that important.

 

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