T C A Srinivasa-Raghavan January 25, 2008
A 1999 paper* by Harrison Hong of the Stanford Business School and Jeremy C Stein of the Harvard Business School brought this out very clearly. They developed the theory which says that basically it is the existence of two views -- optimistic and pessimistic or bulls and bears -- that causes all the problems.
"Because of short-sales constraints, bearish investors do not initially participate in the market and their information is not revealed in prices. However, if other, previously bullish investors have a change of heart and bail out, the originally-more-bearish group may become the marginal 'support buyers' and hence more will be learned about their signals." If you think about it, this is what we are being told to do now, namely, buy when the prices are down. And, indeed, this is what has been happening since Wednesday. (But, if I may add, no one has ever said "sell when the prices are up!")
Be that as it may, Hong and Stein said that the greatest plus point about market falls is that the "accumulated hidden information tends to come out." They are absolutely right. In the next few days we will learn of a lot of firms and industries that have been "performing" so well under the delicate manipulations of speculators.
It is worth reading their paper because it helps us understand "large movements in prices unaccompanied by significant news about fundamentals." In other words, they tell us why things change when there is no reason for them to. Their paper also explains "negative skewness in the distribution of market returns and the increased correlation among stocks in a falling market."
Finally, it makes a prediction that "negative skewness will be most pronounced conditional on high trading volume."
In another paper**, in 2000, the same two authors, along with Joseph Chen, also of the Stanford Business School, had analysed the effects of skewed returns. They concluded that you can get negative skewness if there has been "an increase in trading volume relative to trend over the prior six months; and positive returns over the prior thirty-six months." Just look at the BSE's penny stocks and mid-caps and you get the picture.