Fundamentals and Psychology
in Price Swings
BLOOMBERG’S MARKET WRAP reports indicate that short-term movements in a wide array of fundamental factors —from corporate earnings to the price of oil—underpin participants’ trading decisions in equity and other asset markets. Participants interpret the impact of movements of fundamentals on the prospects and returns of companies over the near and longer term, causing their relative prices and thus their access to financial capital to change. As this allocative process unfolds over time, individual stock prices and broad price indexes also tend to undergo swings of unequal magnitude and duration away from and toward estimates of common benchmark levels.
These observations suggest that swings in asset prices and risk arise from the way that financial markets adjust relative prices and allocate capital. And because such swings depend on how market participants interpret fundamentals in forecasting outcomes, they are ultimately driven by short-term movements in fundamentals. But to account for swings in asset prices and risk on the basis of fundamental factors, we must jettison fully predetermined models. After all, profit-seeking participants revise their forecasting strategies in nonroutine ways, owing to news about fundamentals and to psychological considerations, such as confidence and optimism (which depend on fundamental factors but do not move in lockstep with them).