Welcome!
Welcome to my weekly column. My aim is to give you relevant information that will answer
many of
your questions about investing, help you understand what's going on in the capital
markets, and
perhaps prevent you from making investment mistakes that could cost you money!
There's no law saying the stock market has to be dry and boring, so you can expect a dash
of
humor along the way, too.
Old News is No Longer News
You probably already know the basic relationships between economic variables and the stock
market, but occasionally the timing of those relationships may puzzle you. Most times when
there is
good news about companies or the economy, stock prices go up, and when there is bad news,
values fall. However, recent events put this basic logic in question.
Two weeks ago, the Federal Reserve Board increased interest rates. This happened during a
scheduled meeting, on August 24. Since the meeting was on everyone's agenda well ahead of
time,
analysts speculated on the likelihood of such a move for over a month. Newspapers and
magazines
were filled with stories on how increased interest rates would make stock prices fall -
the usual
relationship. Some observers even studied the size of the briefcase carried by Fed
Chairman Alan
Greenspan in the days leading up to the announcement, trying to gain additional insight.
(Common
lore has it that a bigger briefcase means a rate change.)
Yet, on the day the increase was announced, the stock market actually went up. What's
going on
here?
What's going on is actually perfectly logical. The reason the stock market didn't fall was
because of
all of the attention paid to the expected Fed decision during the weeks leading up to the
announcement. By the time the big day arrived, nearly all analysts projected (accurately)
that the
Fed would raise rates. In fact, the increase was lower than some had expected, which was
why the
stock market rose slightly.
Check It Out!
Let's look at an everyday experience that has a similar dynamic. Pretend you regularly go
to a small
grocery store that has two check-out lines. Before 6:00 p.m., only one of the lines is
open, and as
people get off work the line gets fairly long. Most of the store's regular shoppers know
that the
second cashier arrives at 6:00 every day, always precisely on time (hey -- I said it's
pretend). So,
rather than wait in the long line they will start lining up at the second counter a couple
of minutes
before 6:00.
At exactly 6:00, when the shoppers hear on the store speakers "ester vu
inowoben" (translation:
"register two is now open"), you won't see much movement from one line to the
other. The savvy
shoppers have already relocated into the second line.
Market Efficiency
When consumers react to the available knowledge base in a grocery store, we call it common
sense. When they react to the knowledge base in the stock market, it is called market
efficiency.
The formal definition of market efficiency is that the current level of prices in the
market reflects the
set of information available to investors. So prices should not move solely because a
formal
announcement is made, if the information is already widely known or expected. This is true
for
economy-wide news like interest rate changes and for company-specific news like earnings
announcements.
The next time you see news that should impact a security or the market as a whole in a
particular
manner, and it doesn't, don't assume that nobody cared or that analysts weren't paying
attention. It
is likely that to the true professionals following the market, the formal announcement was
actually
old news, and that price levels had already changed.
Now that we understand this issue, we can focus on the REALLY important topic -- why can't
that
grocery store have the extra cashier come in an hour earlier to prevent the line from
forming in the
first place?  Lummer's Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.
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