Black Monday, Globalization And Trading Behavior Of Stock Investors
Jeong-Ryeol Kurz-Kim
Deutsche Bundesbank
2016
Bundesbank Discussion Paper No. 18/2016
Abstract:
Using a simple sign test, we report new empirical evidence, taken from both the US and the German stock markets, showing that trading behavior substantially changed around Black Monday in 1987. It turned out that before Black Monday investors behaved more as in the momentum strategy; and after Black Monday more as in the contrarian strategy. We argue that crashes, in general, themselves are merely a manifestation of uncertainty on stock markets and the high uncertainty due to globalization is mainly responsible for this change.
Black Monday, Globalization And Trading Behavior Of Stock Investors – Introduction
The economy is largely shaped by certain behavioral patterns of agents. The economic behavior of agents is presumably influenced, in turn, by the given economic circumstances. This reciprocal relationship can also often be observed in speculative markets. It is, therefore, of interest to examine which economic and financial circumstances can influence the behavioral patterns of agents.
Shiller (1987) reports his survey results on investors’ behavior around Black Monday in 1987. One of the findings of his empirical survey is that many investors thought that they could predict the market. This result refers to the time of the crash, but it can be also interpreted to mean that investors thought that they could predict the market for the entire duration prior to Black Monday. This belief of alleged predictability can be interpreted to mean that investors regarded stock returns as a stationary process (with a significant autocorrelation coefficient). Consequently, the sign of returns yesterday seemed to continue today unless the error term (shocks in fundamentals) dominates the autocorrelation from yesterday. This promotes a tendency to co-movement between stock prices and fundamentals, and produces less volatility in stock price dynamics. After Black Monday, investors were more acutely aware of the high uncertainty and risks on the stock markets that were intensified by the globalization of financial markets that has been accelerating significantly since the mid/late 1980s. After the experience of Black Monday, investors seemed to regard stock prices as a random walk process. The belief in the random walk property (i.e. zero autocorrelation of returns between yesterday and today) produces higher uncertainty expressed in terms of higher volatility and, hence, more bubbles and crashes, which is shown analytically in Branch and Evans (2013) who defined this relationship as a self-fulfilling process. To the extend that crashes can be regarded as a financial occurrence which reminds investors of the higher uncertainty and the larger risks on the globalized stock markets.
In this paper, our main concern is whether and how Black Monday in 1987 changed trading behavior on the stock markets. In order to interpret our empirical evidence in terms of economic hypotheses, we apply two concepts of trading behavior; the momentum and the contrarian strategies. The main finding of this paper is that before Black Monday investors behaved more as in the momentum strategy; and after Black Monday more as in the contrarian strategy. This empirical evidence can be observed in both the US and the German stock markets.
The rest of the paper is structured as follows. In Section 2, we propose some test statistics to quantify trading behavior on the stock markets. Section 3 presents some stylized facts found in the two sets of stock price data – the daily Dow Jones index (DJ) and the daily German stock index (Deutscher Aktien Index, DAX) – which show a substantial change in trading behavior before and after Black Monday. Based on these empirical findings, we discuss and hypothesize in Section 4 that the higher uncertainty due to globalization on the stock markets is mainly responsible for this change. Section 5 gives some concluding remarks.
Quantification of trading behavior
In order to establish a link between our empirical findings and economic hypotheses, we introduce two concepts of trading behavior; a day-to-day momentum and a day-to-day contrarian trading behavior. The concepts of momentum and contrarian trading behavior were popularized by Jegadeesh (1990) and Jegadeesh and Titman (1993). In order to apply one of these strategies, investors have to identify winners and losers among the stocks. This identification is based on a certain length of time in the past. In the literature, the duration of this time length is usually few weeks, months or years. Some authors also consider rather very short time horizons. Goetzmann and Massimo (2002), for example, analyze the trading behavior of index fund investors based on the daily momentum and contrarian concepts. In a similar way to the definitions in Goetzmann and Massimo (2002), we also formulate definitions of the momentum and contrarian trading behavior by means of the reaction to previous daily returns as follows.
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