The Myth of Shocks
An Excerpt from Chapter 1 of The Socionomic Theory of Finance
by Robert Prechter
Updated: March 09, 2017
Few people find a new theory accessible until they first see errors in the old way of thinking. Part I of this book challenges the universally accepted paradigm under which humans' rational reactions to exogenous (external, or externally generated) causes purportedly account for financial market behavior. The current chapter explores whether dramatic news events affect financial markets.
Testing Financial-Market Reaction under Perfect Conditions
In the physical world of mechanics, action is followed by reaction. When a bat strikes a ball, the ball changes course.
Most financial analysts, economists, historians, sociologists and futurists believe that society works the same way. They typically say, "Because so-and-so has happened, it will cause such-and-such reaction." This mechanics paradigm is ubiquitous in financial commentary. The news headlines in Figure 1 reflect what economists tell reporters: Good economic news makes the stock market go up; bad economic news makes it go down. But is it true?
In the second half of the 1990s, a popular book made a case for buying and holding stocks forever. In March 2004, after several terrorist attacks had occurred, the author told a reporter, "Clearly, the risk of terror is the major reason why the markets have come down. We can't quantify these risks; it's not like flipping a coin and knowing your odds are 50-50 that an attack won't occur."
In other words, he accepts the mechanics paradigm of exogenous cause and effect with respect to the stock market but says he cannot predict a major cause part of the equation. The first question is, if one cannot predict causes, then how can one write a book predicting effects? A second question is far more important: Is there any evidence that dramatic news events that make headlines, including terrorist attacks, political events, wars, natural disasters and other crises, are causal to stock market movement?
Suppose the devil were to offer you historic news a day in advance, no strings attached. "What's more," he says, "you can hold a position in the stock market for as little as a single trading day after the event or as long as you like." It sounds foolproof, so you accept.
His first offer: "The president will be assassinated tomorrow." You can't believe it. You are the only person in the world who knows it's going to happen.
The devil transports you back to November 22, 1963. You quickly take a short position in the stock market in order to profit when prices fall on the bad news you know is coming. Do you make money?
Figure 2 shows the DJIA around the time when President John F. Kennedy was shot. First of all, can you tell by looking at the graph exactly when that event occurred? Maybe before that big drop on the left? Maybe at some other peak, causing a selloff?
The first arrow in Figure 3 shows the timing of the assassination. The market initially fell, but by the close of the next trading day, it was above where it was at the moment of the event, as you can see by the position of the second arrow. The devil had said that you could hold as briefly as one trading day after the event, but not less. You can't cover your short sales until the following day's up close. You lose money.
You aren't really angry because, after all, the devil delivered on his promise. Your only error was to believe that a presidential assassination would dictate the course of stock prices. So, you vow to bet only on things that will directly affect the economy.
The devil pops up again, and you explain what you want. "I've got just the thing," he says, and announces, "The biggest electrical blackout in the history of North America will occur tomorrow." Wow. Billions of dollars of lost production. People stranded in subways and elevators. The last time a blackout occurred, there was a riot in New York City, causing extensive property damage. "Sold!" you cry. The devil transports you back to August 2003.
Figure 4 shows the DJIA around the time of the blackout. Does the history of stock prices make it evident when that event occurred? After all, if market prices change due to action and reaction, then this surprise economic loss should show up unmistakably, shouldn't it? There are two big drops on the graph. Maybe it happened just before one of them.
The arrow in Figure 5 shows the timing of that event. Not only did the market fail to collapse, it gapped up the next morning. You sit all day with your short sales and cover the following day with another loss.
"Third time's the charm," says the devil. "Forget it," you reply. "I don't understand why the market isn't reacting to these causes. Maybe these events you're giving me just aren't strong enough. What I need is a real shock."
The devil leans into your ear and whispers, "Terrorists will detonate two bombs in London, leveling landmark buildings and killing 3,000 people. Another bomb planted at Parliament will misfire, merely blowing the side off the building. The planners will vow to continue their attacks until England is wiped off the map." He promises that you can sell short on the London Stock Exchange ten minutes before it happens and even offers to remove the one-day holding restriction. "Cover whenever you like," he says. You agree. The devil then transports you to a parallel universe where New York is London, the Pentagon is Parliament and the DJIA is the LSE. It's a replay of September 11, 2001.
Figure 6 shows the DJIA around that time. Study it carefully. Can you find an anomaly on the graph? Is there an obvious time when the shocking events of 9/11 show up? If markets react to exogenous shocks, as baseballs do, there would be something obviously different on the graph at that time, wouldn't there? But there isn't.
Authorities closed the stock market for four and a half trading days after the 9/11 attack, and it stayed closed over the following weekend. Was it certain that the market would re-open on the downside? No. Some popular radio talk-show hosts and administration officials advocated buying stocks on the opening just to "show 'em." You sit with your short position, and you are nervous. But you are also lucky. The market opens down, continuing a decline that had already been in force for 17 weeks. You cheer. You're making money now! Well, you do for five days, anyway. Then the market leaps higher, and somewhere between one and six months later (see Figure 7) you become disgusted and confused and finally cover your shorts at a loss.
The devil spreads his hands in apology. "Wait! You saw how it worked for a few days! I can't help it if you held on too long." You start to walk away. He gives it one last shot. "I know. You need something that's going to work long term. How would you like to take a long term trade that's guaranteed in print?"
You hesitate. He says, "I happen to know of a devastating event that future historians will describe as 'the costliest natural disaster in the history of the United States.' Does that sound promising?" You're not sure. "Where is it going to hit?" "New Orleans will get the worst of it." "Forget it. I can't short New Orleans." The devil smiles slyly. "No, but you can buy oil futures contracts. Hang on. Just read this future description of the effects of the event, which will be available on the Internet ten years after the fact." He hands you this report:
Katrina shut down 95% of crude production and 88% of natural gas output in the Gulf of Mexico. This amounted to a quarter of total U.S. output. About 735 oil and natural gas rigs and platforms had been evacuated due to the hurricane. The price of oil fluctuated greatly. According to [a spokesman on the scene], "half billion dollars a day of oil and gas is unavailable. Hurricane Katrina will impact oil and gas infrastructure, not just short term but long term as well." The storm interrupted oil production, importation, and refining in the Gulf, thus having a major effect on fuel prices.
"C'mon!" he says. "You can't get a better guarantee than that!"
You think, "He's right. It's there in black and white: 'a long term impact... a major effect on fuel prices.'" This is the trade you've been looking for. You agree to go for it. The devil transports you back to the early morning of August 29, 2005, the day Hurricane Katrina hit shore. As soon as the market opens, you buy an armload of oil futures contracts. You sit back and wait for the outcome future historians had described.
Figure 8 shows the day you placed your all-out bullish bet: August 29, 2005, right at a top in oil prices and just before a three-month slide of over 20%. You are stunned. A record-breaking, surprise disruption in the supply of oil failed to make oil prices zoom. On the chart, it even looks as if somehow the event made prices fall. You are bewildered. You took Econ 101 in college, and the market's reaction makes no sense. You finally sell out, taking a loss.
You look into the history of the matter and come across a footnote on Wikipedia saying that President G.W. Bush had released oil from the U.S. Strategic Petroleum Reserve in the wake of Katrina. Maybe that was the devil's secret! But, no. The U.S. was consuming 21 million barrels of oil a day at the time, and the Reserve over a period of weeks released only half a day's worth.
You pull out a historical chart of oil and discover that even in late August 2007, two years after the event, its price was exactly the same as it was on the day you had bought, even though oil was in the middle of a monstrous bull market in which its price soared over 1300% from 1998 to 2008. Somehow your purchase caught one of the few setbacks within it.
You do a Google search, and there it is—the passage the devil had read. The historians lied. They must have figured that a disaster of such magnitude simply had to have a major effect on oil prices, so they just said it did. Their devotion to exogenous-cause logic obscured their perception of history.
You take a day off to do some research and come across an exhaustive, 40-year study of the impact of 177 large earthquakes on the returns of stock market indices in 35 different countries from January 1973 to August 2013. You read that despite limiting the earthquakes under study to those causing at least 1,000 fatalities or a minimum of $25 million in property damage, the authors were able to identify "No systematic effect of earthquakes on aggregate stock market indices, either directly or through the control variables." Then you realize: This must go for assassinations, blackouts, terrorist attacks and hurricanes, too.
If you are an everyday thoughtful person, you decide that events are irrelevant to markets and begin a long process of educating yourself on why markets move as they do. If you are a conventional economist, you don't bother.
Now think about this: In real life, you don't get to know about dramatic events in advance. Investors who sold stocks upon hearing of the various events cited above did so because they believed that events cause changes in stock values. They all sold the lows or bought the highs. I chose bad news for these exercises because it tends to be more dramatic, but the same irrelevance attaches to good news.
Exogenous-Cause Claims Lead to Perverse Conclusions
Economists often say that an unexpected "shock" would cause them to re-evaluate their bullish stock market forecasts. It does seem logical that a scary event such as a destructive terrorist attack, particularly one that implies more attacks to come, would be bearish for stock prices.
Take a moment to study Figure 6 again. Surely all of those exceptionally dramatic swings in the DJIA must have been caused by equally dramatic news: bad news at each of the peaks and good news at each of the bottoms. At least that's what the exogenous-cause model would have us believe.
As it happens, there was a lot of scary news during this time. Aside from the 9/11 terrorist attack on the World Trade Center and the Pentagon, there was also a slew of mailings of deadly anthrax bacteria, which killed several people, prompted Congress to evacuate a session and wreaked havoc lasting months. Where on the graph of stock prices in Figure 6 would you guess the anthrax mailings happened?
If you guessed, "the very day of a rally high and all through a four-month stock-price collapse," befitting exogenous-cause theory, Figure 9 would vindicate you. It shows that the first anthrax attack occurred precisely on the top day of a rocketing advance that appeared destined to take the Dow to a new all-time high. The stock market reversed sharply and then fell throughout the period of attacks. When the attacks stopped, the decline stopped, and the market turned on a dime and soared. Good for you and exogenous cause theory!
The only problem with your case is that Figure 9 is a lie.
Figure 10 tells the truth. The first anthrax attack actually occurred on the very day of the low for the year, after a dramatic, 18-month decline in the Dow. Afterward, despite six more attacks and public concern that more were in the works, the stock market rallied for six months. These attacks, deaths and scares, moreover, occurred throughout the strongest rally on the entire graph. To put it more starkly, the market bottomed the day the attacks started and topped out as soon as people realized they were over.
Figures 7 and 10 reveal an irrefutable fact: Terrorist attacks do not make the stock market go down. The assumption behind economists' repeated implications that terrorist attacks would constitute an "exogenous shock" that would serve to drive down stock prices is simply wrong.
Since even possessing advance secret knowledge of highly dramatic, surprise events provides no advantage for speculating, guessing about coming events is an utter waste of time. There can be no causes related to external events that even the most prescient person could exploit.
It gets worse. From the viewpoint of exogenous cause, Figures 3, 5, 7, 8 and 10 make it appear as if the assassination of President Kennedy was bullish, the New York City blackout contributed to a rally, Hurricane Katrina caused oil prices to drop, and terrorist attacks made stock prices soar. These conclusions are discordant and perverse.
People object, "You can't tell me news doesn't move the market. I see it happen every day!" But they don't see any such thing, and it takes careful study to reveal that they don't. Consider: If the market's moves and the tenor of news were independently random, the two types of events would still fit each other half the time, wouldn't they? That's more or less what people see, and they expand those coincidences into what they think they see.
As this chapter shows, the notion that exogenous shocks change market trends is highly suspect. Chapter 2 will broaden the scope of our investigation. As we will discover, a fundamentally different theory of social causality accounts for the chronology so as to turn discordant perversity into harmonic compatibility.
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