Thursday, September 30, 2010

Less Basic Mistakes: Reading Stock Market Tea Leaves and the Fed

I have long been skeptical of news reports' attempts to explain why stocks moved by 0.5% on a given day, even before I knew about the EMH. Sumner makes a great point about the circularity problem of stock markets responding to expectations about how the Fed will respond to news and Feds responding (as the do on occasion) to stock market changes:
So let me get this straight:
1.  The markets were weak in August, causing a low consumer confidence number in September
2.  This leads investors to expect more easing by the Fed
3.  This leads to a stronger stock market
4.  This will lead to a better consumer confidence number in October
5.  Which will lead investors to fear the Fed won’t ease
6. Which will cause stock prices to fall in October
7.  Which will lead to a weaker consumer confidence number in November.
8.  And so on
Are you getting dizzy yet?  This is the so-called “circularity problem,” ...
So if the Fed were to meet in November and decide not to do QE because the market was looking up, and if the market was looking up because they expected QE in response to weak economic data, then the Fed could end up with a nasty surprise.  Something like what occurred in December 2007 and January 2008, or again in September 2008 and October 2008.  Using Wall Street lingo, they could “fall behind the curve.”

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