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December 3, 2007

Robert Shiller: Something's Up as 'Buy' Confidence Slips

Robert Shiller takes a look at the stock market's "unusually negative skew":

Something's up as 'buy' confidence slips, by Robert Shiller: The sharp drop in the world's stock markets on Aug. 9 — after BNP Paribas announced that it would freeze three of its funds — is just one more example of the markets' recent downward instability or asymmetry. The markets have been more vulnerable to sudden large drops than they have been to sudden large increases.

Daily stock price changes for the 100-business-day period ended Aug. 3 were unusually negatively skewed in Argentina, Australia, Brazil, Canada, China, France, Germany, India, Japan, Korea, Mexico, the United States and Britain. ... In the U.S., the skew has been this negative only three other times since 1960...

Stock markets' unusually negative skew is not inconsistent with booming price growth in recent years. The markets have broken all-time records, come close to doing so or, at least, done very well since 2003 ... by making up for the big drops incrementally, in a succession of smaller increases.

Nor is the negative skew inconsistent with the fact that world stock markets have been relatively quiet for most of this year. With the conspicuous exception of China and the less conspicuous exception of Australia, all have had low standard deviations of daily returns for the 100-business-day period ended Aug. 3 when compared with the norm for the country. ...

Indeed, one of the big puzzles of the U.S. stock market recently has been low price volatility since around 2004 amid the most volatile earnings growth ever seen. ... One would expect volatile market prices as investors try to absorb what this earnings volatility means. But we have learned time and again that stock markets are driven more by psychology than by reasoning about fundamentals.

Does psychology explain the pervasive negative skew in recent months? Maybe we should ask why the skew is so negative. Should we regard it as just chance or, when combined with record-high prices, as a symptom of some instability?

The adage in the bull market of the 1920s was "one step down, two steps up, again and again." The updated adage for the recent bull market is "one big step down, then three little steps up, again and again," so far at least. No one is looking for a sudden surge, and volatility is reduced by the absence of sharp upticks.

But big negative returns have an unfortunate psychological impact on markets. People still talk about Oct. 28, 1929, or Oct. 19, 1987. Big drops get their attention, and this primes some people to be ... ready to sell if another one comes.

In fact, willingness to support the market after a sudden drop may be declining. The "buy-on-dips stock market confidence index" that we compile at the Yale School of Management has been falling gradually since 2001, and has fallen especially far lately. The index is the share of people who answered "increase" to the question "If the Dow dropped 3 percent tomorrow, I would guess that the day after tomorrow the Dow would: Increase? Decrease? Stay the Same?"

In 2001, 72 percent of institutional investors and 74 percent of individual investors chose "increase." By May 2007, only 48 percent of institutional investors and 59 percent of individual investors chose "increase."

Perhaps the buy-on-dips confidence index has slipped lately because of negative news concerning credit markets, notably the U.S. subprime mortgage market, which has increased anxiety about the fundamental soundness of the economy.

But something more may be at work. Everyone knows that markets have been booming, and everyone knows that other people know that a correction is always a possibility. So there may be an underlying sensitivity to price drops, which could fuel a succession of downward price changes, amplifying public concerns about problems in the economy and heralding a profound change in investor sentiment.

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