Reasons for Stock Market Volatility

June 26th, 2008 | finance -

“There is a saying: stock markets have predicted 10 out of the last 3 recessions.”

Readers Question: That does not make sense – how can you predict 10 out of 3? Did you mean 3 out of 10?

The rationale behind the statement “stock markets have predicted 10 out of the last 3 recessions.” is that stock market volatility does not necessarily reflect economic conditions.
Sometimes stock market investors panic; they think share prices are overvalued or some bad piece of economic news makes them fearful about future economic conditions. These small signals can, in some circumstances, can cause a rapid fall in share prices. The fall can then precipitate panic selling and share prices suddenly lose a large % of their value. However, later, it is realised that the stock market has overreacted to a piece of bad news and actually conditions are not as dire as they feel.

Example,

Stock Market Crash of October 1987

On October, 1987, stock markets around the world fell by about 25% in the space of a week. Many at the time felt this was due to an impending recession. However, economies continued to grow and the recession never materialised. Therefore, the stock market crash, was not based on economic fundamentals, but, a chain of situations making people nervous and wanting to sell.

If a recession is coming, share prices will fall because a recession will mean lower profits and possibility of bankruptcy. However, just because share prices fall doesn’t mean the economy is going to do badly.

Also, I think the statement is a bit ‘tongue in cheek’ but, it is trying to emphasise the point that share price volatility is often divorced from economic reality.