Imagine a natural disaster so big that the damage equaled 15% of a country's gross domestic product (GDP).
Would such a major event affect that country's main stock index? Many people would say "Yes," and expect the stock index to decline.
This is not a hypothetical scenario: Recent history includes just such an event, so we know what direction market prices took after the disaster. Look at the chart below and try to identify the approximate time when this hugely destructive and costly (lives and treasure) event occurred:
Did you think the disaster happened around that mid-'90s top? Or perhaps around the 2007 top? Those would be rational answers, if outside events really do influence stock market trends. The April Global Market Perspective reported:
"On February 27, 2010, the sixth largest earthquake ever recorded by a seismograph struck Chile...The relative economic damage was one of the most expensive in contemporary world history.
"And yet … Chile’s stock market fell merely 3% over the next three trading days and then made up all those losses over the next seven. The effect on the stock market’s long-term pattern was almost imperceptible. Does that seem rational?"
You can see the price action which followed the historic Chilean quake on the weekly chart below (wave labels removed):
As you can see, the Chile General Index continued sideways for a few months after the earthquake, then rallied for about a year before experiencing a correction!
Therefore: If external events drive stock index trends, the rational conclusion is that devastating news is bullish. (By the way, stock prices also rallied following the Sept. 2010 earthquake that struck Christchurch, New Zealand.)
But, of course, external events do not drive market trends. The truth is that investor behavior is non-rational.
Let's return to the April Global Market Perspective::
"The Wave Principle...offers a far better way to make sense of the apparently non-rational responses of stock markets to devastating events. It shows that exogenous shocks have only short-term effects on a stock market’s long-term endogenous pattern."
Indeed, endogenous (or internally regulated) stock market patterns are the key to future prices. Markets are governed not by rationality, but by collective psychology.