Markets Don’t Overreact to Disasters

I recently came across the following in a local paper called The Improper Bostonian:

When the British Petroleum rig exploded in the Gulf of Mexico, the stock plummeted from about $60 to $27.  it was an emotionally charged issue, and rumors of bankruptcy for BP echoed widely.  But once the tragedy was off the front pages, the stock rallied to $46.  The sell-off had been exaggerated by emotions and media frenzy.  After the tragic earthquake in Japan, big market sell-offs occurred again.  Two weeks later Japanese stocks bounced back, and a few commentators even talked about how the resulting potential for change created bullish markets.

This is false.  Markets don’t react emotionally to disasters.  The Japanese market did not overreact, it processed information very rationally.  In contrast to John Spooner’s assertion, the initial reaction in Japan was actually an under-reaction, and prices fell further as more information came in about the severity of the nuclear problem.  Then prices rose somewhat when the worst case was avoided.  Here are some Nikkei closing levels:

March 10  10,410

March 11  10,254   (Tsunami occurred at 2:46 pm)

March 14,  9,620

March 15   8,605

March 16   9,093

March 17  8,963

March 18  9,207

March 21  9,608

After that, prices tended to level off, roughly 10% below pre-tsunami levels.

Here’s the mistake Spooner made.  Take any negative news shock.  Then follow the stock market from the date of the shock to the present.  In 99% of cases the current price will be higher than the lowest post-shock price.  That’s simply the nature of any random walk series.  Only in the rare case where the current price IS the lowest post-disaster price, will current prices not be higher than the post-disaster lows.

At first glance it looks like the “overreaction” created a great buying opportunity.  But that’s an cognitive illusion, as no one at the time knew which price was the post crash low. If you bought Japanese stocks on the Monday after the tsunami, you paid too much–the tsunami had not yet been fully priced into stocks, as the extent of damage was still not fully realized.  Almost by definition, the low point (whether in Japan or the BP case) will be an overreaction to the disaster, as it will incorporate the most pessimistic damage estimates of the entire post-disaster period.  But in real time we don’t know when that overreaction occurred, each price point is fully rational, given what investors know at the time.

Just one more example of how cognitive illusions cause many people to mistakenly reject the EMH.

BTW, I am not suggesting that all opponents of the EMH are irrational, just that some anti-EMH arguments are based on cognitive illusions.  There are obviously some more respectable anti-EMH arguments, although in the end I don’t believe those arguments have practical applications.

• Become A Funded Futures Trader