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How Bad News Can Cause Stock Prices to Go Up

There is a reason why Robert Shiller was awarded a Nobel prize for his amazing research showing that valuations affect long-term returns. If that research is legitimate (I believe that it is), then it changes everything that we once thought we knew about how stock investing works.

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We believe that it is positive economic developments that cause stock prices to go up and negative economic developments that cause stock prices to go down. That seems intuitive. It makes sense. But what Shiller showed is that much of stock investing does not make sense. Stock investment choices are made by humans and humans are highly emotional creatures. Investors are as likely to reject logic as they are to follow it.

Correlation Between Bad News And Stock Prices

In a world in which emotion is dominant and reason has only a secondary effect (often being employed to develop arguments used in support of emotional choices), one cannot assume that positive news leads to price gains and that bad news leads to stock price drops. It could be just the opposite.

Stock prices are very high today. They are at levels just a notch below the levels that brought on the Great Depression. Most investors are only vaguely aware that this is the case. Most have heard that valuations are on the high side. But most do not follow valuations closely enough to be able to specify with any precision what that means. But investors want prices to go higher (so that their portfolio value will be larger) and thus see a threat in news reports that on the surface might seem negative.

Take the news that Joe Biden has been elected President but that Republicans appear likely to hold onto control of the Senate. Stock prices have soared in the first few days following the election. The explanation that has been offered is that investors find appeal in divided government. But do we really know that that’s the case? The journalists who wrote the articles offering this explanation interviewed a few investment professionals and those investment professionals offered a take that sounds plausible enough.

It makes sense to buy into plausible explanations in a world in which investor rationality is assumed. That is the world in which we lived prior to the publication of Shiller’s research on irrational exuberance. Investor rationality is not a safe assumption in a post-Shiller world. In fact, at a time when the CAPE value is as high as it is today (indicating a high level of emotionalism in the market), we should be looking for not terribly plausible explanations of stock price changes, explanations that don’t make a great deal of logical sense but perhaps make some emotional sense.

Could it be that the voters’ choice of divided government is actually an economic negative? Could it be that investors’ first reaction to the election results is that they made it less likely that legislation that is needed to keep the economy strong will be adopted and that the stock market should be priced lower today than it was before voters went to the polls? But that investors’ fears of a price drop kept them from acknowledging that this is the case and so instead of pushing prices down a bit they pushed them up a bit instead to hold off a price crash a bit longer?

What Causes Prices To Rise And Fall?

I of course am not able to say that that is in fact the case. I am speculating. But the point that I believe needs to be better understood is that the conventional explanation of the price jump is speculation too. We simply do not know what causes prices to rise or fall. We got in the habit of presuming that the market was responding rationally to events in the days when we believed that the market is efficient. Those days are over for those of us who believe that Shiller’s Nobel-prize-winning research is legitimate. We need to begin thinking about both price increases and price drops in new ways.

Here’s why. If Shiller is right, stock prices have been going up and down for all sorts of crazy reasons for as long as there has been a stock market. We have assumed for many years that the price changes that took place made sense. Then, one day, the crazy prices that we accepted because we thought they made sense crashed back to realistic levels, causing an ocean of human misery. Assuming rationality where it does not exist is a dangerous habit.

When we all become more skeptical of “just so” stories about why stock prices have risen or fallen, we will place less confidence in those prices and will take less delight in the increased wealth that we tell ourselves they signify. If prices can rise or fall for all sorts of crazy reasons, then we cannot take much comfort in the elevated sense of financial security that bull markets provide us and that make them so alluring. Anything that causes us to doubt the reality of high stock prices will cause prices not to rise quite so high. Which would translate into a less risky stock market.

It’s by coming to terms with our irrationality that we can make better choices as investors. Which is the most rational choice that we can make!

Rob’s bio is here.


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