Thursday, February 23, 2012

Causality or Simply Correlation: Does the Stock Market React to Real World Events?

When you read the headlines of the day, you'll quickly note that every movement of the stock market or a particular stock can be explained by some thing that is happening in the world.  " Dow drops 237 points as fears of Greek default intensifies," or "stock futures rise as housing market bottoms"...etc.  At times, it appears that the two do correlate.  When the economy is doing well, the stock market goes up.  The questions I would like to pose are: Do real world events cause movements in the stock market?  Or is the reverse true?  Or are they simply correlated without real cause-and-effect?

Bathrooms and SAT Scores
Before I give you my thoughts.  Let me give an example that I read somewhere.  It could have been Freakonomics (interesting book, by the way), but maybe not.  In any case, it was said that SAT scores of highschool students in the US had a high correlation to the number of bathrooms they had in their house.  That seems kind of silly, doesn't it?  Thinking a little deeper, it actually makes perfect sense.  Which kids have many bathrooms in their house?  Kids with a big house.  And who owns big houses?  Those from affluent families.

As further research shows, students from affluent families often perform better than their counterparts from a more modest background.  The causal link is between family affluence (or better yet, the environment provided by an affluent family) and SAT scores.  Since there is high correlation between affluence and number of bathrooms in the home, there is also high correlation between number of bathrooms and high SAT scores. 

One of the dangers in this situation is creating a stereotype that kids with lots of bathrooms in their house will perform better in school.  The larger problem, however, is asserting a causal link between number of bathrooms and high SAT scores.  A parent, learning of this correlation between number of bathrooms and high SAT scores, may mistakenly decide to spend money putting in new bathrooms in the house rather than on tutors, to improve his child's performance in school.  It sounds ludicrous, but it's not entirely unfathomable. 

Headlines Are Mainly Noise
You've probably already guessed where I'm going with this... As with bathrooms and SAT scores, business journalists probably confuse correlation with causality on occasion.

The stock market is really just a reflection of the buying and selling transactions that occurs.  On a day where more people want to sell than buy, the stock market drops, and vice versa.  That is the main causal link between real world events (i.e. people buying/selling) and stock market movement.  One can only guess at what causes people to buy or sell.  Sometimes, the cause of selling may be entirely cyclical.  Fund managers may participate in an activity called, "window dressing", where they will buy up stocks that have recently performed well as it gets closer to the date they disclose their holdings.  This makes it look like they had made great picks.  If enough fund managers do this on a particular day, it could be a market moving event.  But how often do you see this reported by journalists?

The point is that there are so many factors affecting the stock market transactions such that to make the assertion that the market or even a stock moved in a particular direction as a result of a particular event could be wrong.  Therefore, headlines, at many times, are a source of noise.  In short, take it with a grain of salt.

Useful Causal Links
If we can't trust journalists, what can we trust?  The answer may be a little provocative: ourselves!  When it comes to investing, we really should do our own research.  Aside from the ethics side of things, we need to estimate the value of a company.  The causal link between a stock's price and its earnings power is strong in the long term.  A stock may get beaten down due to whatever reason, but if it continues to grow its positive cash flow, its price will eventually reflect that.  High earning power causes higher stock price.  It is that simple!

Therefore, it is key to be able put a value on a company based on the outlook of its earning power.  If the price is sufficiently below the value, then it is time to buy.  Conversely, when the price rises much higher than the value, we should consider selling.  Again, this goes back to doing the right fundamental analysis on a stock.  If you're new to this blog, start by going to Fundamental Analysis or Rule #1 Investing.