Where's the Optimism?

Stock surges erased last week’s crash, yet Americans remain in a funk. Zachary Karabell on why bad news trumps good—and the computers running the markets don’t care about either.

In the past three trading days, U.S. markets recovered everything they lost last week. In the wake of S&P’s disastrous and ludicrous downgrade, the major indexes lost about 8 percent; since then they’ve gained that entire amount back and then some.

The rapid moves down last week led to a wave of analysis, portending a market-predicted double-dip recession, a waning of corporate profits, a worsening of funding crises in Italy, Greece, Portugal, and the entire European Union, and perhaps a collapse of fiat currencies ranging from the euro to the dollar. The moves the past three days, therefore, should have occasioned a wave of analysis heralding the stability of the U.S. economy, the health of the EU, the resurgence of Japan post-tsunami, the continued strength of China, and the ongoing commodity and industrial boom throughout the world formerly known as emerging.

But no. The fears of last week and the hand-wringing occasioned by the downgrade have not been magically replaced by a surge of hope and optimism. This is illogical—if, that is, you accept the logic that the markets are economic-forecasting mechanisms. After all, if they are accurately forecasting turbulent economic times on the way down, they ought to be forecasting rosy days on the way up. But two things prevent three good market days from inverting the pyramid of doom.

First, the logic is actually wrong. It’s been said that markets have accurately predicted 10 of the last six recessions. Sometimes extreme weakness in stocks is a proverbial canary in that mine; but other times, as in October 1987, or in 1998 when markets were spooked by the failure of Long Term Capital Management, selloffs presage absolutely nothing. They are not forecasting; they are reflecting massive buying and selling by a relatively small number of participants.

Markets don’t forecast anything, though forecasters use them as specious proof of questionable arguments.

As many have noted in marketland this past week, a significant amount of the selling, and now the buying, has not been by institutional investors reading the economic tea leaves or by individuals panicking, but by high-frequency trading. High-frequency trading is hard to track, but most informed observers believe it may account for as much as two thirds of all volume of shares traded, and last week that percentage is believed to have been even more.

The fact that no one knows is itself a source of concern. When shares are traded electronically, it is currently impossible to know if it was you on your e-Trade account or an algorithmically driven hedge fund executing trades by the millisecond. But there have been studies (including the recent “The Dark Side of Trading”) that show that the more electronic volume there is, the more volatility there is. Basically, high-frequency trading thrives on volatility—on precisely the up-5-percent, down-5-percent, up-5-percent days that the market gave us the past week and a half. And the more shares that trade in extreme swings, the more those algorithms trigger more trades, and the more extreme the swings become.

So while the market moves this past week were triggered by concerns about the real world, once triggered they began to move on their own, driven by trades based on motion and velocity, and not on economic data or company earnings.

Yet that doesn’t stop vast numbers of people—especially on Wall Street and in the media—from making hard and fast conclusions about economic health based on market moves. Invariably, these conclusions mirror already existing views. Those who think the economy is on the brink use market panic as proof that the economy is on the brink. And when markets soar, bullish analysts add that as an arrow to their quiver.

Often, negative and positive views cancel each other out over time. But that leads to the second major problem with how market behavior is used: In the United States and Europe, we live in a time when public confidence is plummeting. According to the most recent Gallup poll, barely 20 percent of Americans of all political persuasions believe that the country is headed in the right direction. The U.S. economy is working for some people (note: see Apple), but clearly not working for vast swaths of others. And Wall Street and corporateland, as much as they are thriving, are unsettled by the combined pressures of popular anger and global trends that they can’t control.

The result is that bad markets feed negative sentiment far more than good markets feed positive sentiment. Even as markets have recovered strongly since May 2009, and with them millions of 401(k) plans and pensions, public attitudes have not. Sure, much of this is connected to weak employment, but even there, even factoring in as much as 20 percent underemployment along with unemployment, 80 percent of people have jobs, and perhaps 50 percent have decent jobs. But 50 percent don’t believe the United States is headed in a good direction (and attitudes in Europe are similarly grim). Information that confirms that—markets tanking—is heeded. Information that doesn’t—markets rising—is largely dismissed.

So if markets not only continue to stabilize but actually rise over the coming weeks and months, don’t expect a rash of headlines about how that reflects well on the economy. After all, as many will be quick—and correct—to point out, the strength of many companies whose stocks are traded exists despite deep weakness on Main Street. Companies can and do shed labor and buy information technology in order to maintain profitability. But vibrant and rising markets do provide a cushion for our economies, and they certainly benefit retirement plans and some consumer spending.

Nonetheless, the lesson of the past week should be simple: Markets are not economies, and economies are not markets. Over time, yes, stock prices have a relationship to the underlying strength of the companies over which they are small slices of ownership. But in a two-week period of extreme volatility, all that goes out the window and markets reflect … markets. They don’t forecast anything, though forecasters use them as specious proof of questionable arguments. And in times of worry and anxiety, only bad markets are held up as barometers, making a mockery of the idea that they are barometers of anything except the manic-depressive sentiments of investors and indeed of entire societies in our brave, confusing, electronically interconnected world.