Let’s All Please Stop Overreacting to Bernanke’s Remarks
Twenty-four hours is the new two months.
That’s my conclusion from the furious market reaction we’ve seen since Wednesday afternoon to Federal Reserve chairman Ben Bernanke’s remarks about the central bank’s future plans for bond purchases.
These were relatively mild statements, signaling the potential for action in the distant future. But markets didn’t waste any time responding.
In the last couple of hours of trading Wednesday afternoon, the Dow Jones Industrial Average lost 186 points, and the interest rate on the 10-year government bond rose by 11 basis points, or about 5 percent. The carnage continued Thursday. The Dow fell more than 300 points, and the interest on the 10-year soared another 11 basis points, for a two-day move of 10 percent.
The predominant school of thought holds that the markets are irrationally acting—and crashing—in response to the news. After all, nothing Bernanke said could—or should—cause vast asset classes to lose so much value in so short a time.
On the other hand, it could be that the market is more rational than we think. What we’re seeing could simply be a much more rapid absorption and processing of information. In the olden days, say, five or 10 years ago, investors would see a new piece of information, think about what it meant, perhaps have a meeting or two, and then position their portfolios for possible changes. Yes, there would be some instant reaction. But it might take a few weeks or months for the market to fully absorb a new reality—that a particular sector is booming, or that a particular company is failing.
But the markets have changed. As with everything else in life, there’s virtually no time to think. Consider how the news cycle chews up and spits out stories with much greater speed today. The markets work the same way. High-frequency trading computers execute hundreds of trades per minute, largely on autopilot. Computerized trading programs react to trends in the market and then amplify those trends. If the machine is programmed to hit sell once a stock drops 4 percent, it will create a new supply of stock for sale precisely at the time it is falling, which only exacerbates the decline. (That’s how we got the flash crash back in 2010). The markets are far more procyclical than they were in the past—which means if they’re moving sharply in one direction on any given day, the tendency will be to move even more sharply in that direction.
Trade now, ask questions later.
But here’s the thing. The Fed hasn’t done anything yet. It hasn’t even said precisely when it will do anything. Bernanke simply said that the central bank might reduce the pace at which it acquires bonds at some point later this year, and that it might stop doing so altogether if unemployment falls sharply enough next year.
In time, you’d expect such actions to have negative impacts on both bonds and stocks. With the Fed buying fewer bonds, rates will have to rise to attract buyers. And higher interest rates tend to be bad for stocks. But investors aren’t waiting for the Fed to act. If the world is going to change at some point in the future, the smart money says, why not adjust your portfolio accordingly? What’s happened the last two days is that everybody has adjusted their portfolios for actions that might occur several months from now—at the same time. The result: a mini-crash.
My point is this. In a world in which the Fed is less of a player in the bond market and is thinking about tightening the money supply, it may make complete sense for bonds and stocks to be trading at their current levels. The Federal Reserve certainly would prefer an orderly progression to that stage. The Fed, in fact, spends a great deal of time and energy managing the information flow to produce gradual, nondisruptive market changes. It uses leaks, speeches, statements, and press conferences to float ideas, hint at them, point to them, and then finally execute them.
The problem is that the Fed is operating an analog strategy in a digital world. It’s riding a three-speed bike in a world of 21-speeds. It’s a marathon runner in a world of sprinters. It’s leaving lengthy voice mails in the age of Twitter. It’s tacking like a careful sailboat while everybody else is driving hopped-up powerboats.
I’m out of metaphors here, so I’ll conclude. Rather than calmly, slowly processing the new information Bernanke is communicating to the market, the investment complex processes it in a day or two. And faster isn’t always better.