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Prices drive the news, not just a good story

THE return of volatility in the first quarter versus 2017 was our focus last week. Some interesting pushback followed the premise that prices seem to ignore news sometimes and at other times hang on every headline.

My explanation: Most people have this correlation backward. Contrary to widespread belief, the news does not drive markets or prices; rather, it is the markets that drive news. As I wrote: Last year, the US launched missiles at Russians fighting in Syria, and the market closed up that day. The US made ominous-sounding threats against the rogue regime of North Korea, and Mr Market shrugged. President Donald Trump was beset by multiple scandals that could threaten his presidency and yet markets kept rising.

Compare that with this year, when tensions ratcheted up with North Korea and the S&P 500 took a thrashing. Or how about a trade war? Mr Trump got serious about that this year, and markets reacted in kind - negatively, that is. And yet, this should hardly be a surprise to anyone, since a populist-protectionist agenda is what the guy literally campaigned on.

If you believe the market is remotely efficient, that it typically incorporates all known information into prices, then none of the above should come as a surprise.

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You don't believe price drives news? My favourite example was during the early weeks of the war in Iraq. A headline one morning proclaimed, "Historic Mosque Bombing Sends Stocks Lower and Oil Spikes Higher." That is the classic narrative explanation, that this event caused that reaction. But it is often misleading, given how random day-to-day prices can be and how quickly they can reverse themselves.

Indeed, by the end of that day, stock prices had recovered to turn positive, and the oil price spike ended as quickly as it started. The article headline was changed to: "Despite Historic Mosque Bombing, Stock Prices Recover and Oil Stabilises."

In the print-only era, the daily headlines were less easily shown to be so wrong. The 24/7 Internet era reveals more of these narrative errors.

The news media has gotten better at using the word "as" instead of phrases like "because" or "due to". If that same news story occurred today, it might have carried a headline like "Stocks Fall, Oil Rises as Historic Mosque Bombed." It is a recognition of a correlation without the implied narrative-driven causation.

Genuine news can drive prices - previously unknown scandals, takeovers, and earnings misses are the stuff that can move stocks and markets. This is information that isn't already reflected in prices. However, most media coverage reflects the normal human bias to tell memorable narrative stories rather than rely on dry and easily forgettable data.

Consider the evidence for this:

  • Narratives: Columns and articles all use the traditional tools of literature. There are well-developed characters, often in conflict with one another, with overtones of good and evil. The story arc builds to a climax, with winners and losers. The narrative tale often is compelling and even entertaining.
  • Threat awareness: Evolution has primed your brain to identify possible threats to your survival. It is fair to note a manifestation of this in our collective focus on bad events versus the signs of progress or even good news. Danger is an existential risk, potentially reducing your ability to pass your genes along. Good news does not provide a competitive procreative benefit. Not focusing on risks means those who are "risk-neutral" did not pass along their genes, to the advantage of those who were "risk-sensitive".
  • Disproportionate coverage: The news media can create a distorted view of the world. For example, US news outlets tend to overemphasise domestic events while under-representing overseas coverage. This creates and reinforces a worldview that is simply at odds with reality.

The tendency to think in terms of unproductive, money-losing narratives is ever-present. We see it with explaining market corrections, politics, gold, elections, venture-capital investments, financial crisis analyses - you name it.

Narratives create memorable and interesting stories, but they don't create an especially accurate picture of the world. Investors should be aware of this. BLOOMBERG

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.