Stock market plunges and soars. Is it acting irrationally?

Swings of hundreds of points up or down have investors wondering if the stock market is irrational. Analysts say the volatility reflects uncertainty about the economy. Get used to it.

Brendan McDermid/Reuters
A screen displays the final numbers for the Dow Jones Industrial Average on the floor of the New York Stock Exchange, Aug. 11. After dropping nearly 520 points on Wednesday, the stock market soared almost 423 points on Thursday.

One day the stock market loses 500 points in a spate of pessimism. The next day the gloom lifts and the market swings back, rising 500 points.

The wild swings are enough to make investors wonder if the market is overreacting? Is it irrationally nervous?

On Thursday, investors could legitimately ask those questions as stocks went through another wild day. After dropping nearly 520 points on Wednesday, the Dow Jones Industrial Average soared almost 423 points on Thursday.

Stock market observers say the high level of volatility might well be around for a while. Over the long term, stock prices might begin to reflect the economy and corporate earnings. But, over the next few weeks, fasten your seatbelt.

Peter Coleman, director of research at JMP Securities in San Francisco, says the volatility is in part because of a high level of uncertainty over the future of the economy and the issues surrounding the financial stability of the European banks.

“The market is trading off every bit of information that comes out one way or the other,” says Mr. Coleman, a market watcher for 19 years. “The market is going to continue to be volatile.”

Another reason for volatility, says Pittsburgh investor Andre Weisbrod, CEO of STAAR Financial Advisors, is the stocks of many companies are screaming, “Buy Me,” because their valuations have sunk so low but their balance sheets and earnings prospects appear good.

On Thursday CNBC reported that company executives had increased their purchases of their own companies’ stocks. This is sometimes considered a sign they recognize a good bargain.

But, at the same time, traders looking at charts of the stocks are nervous about buying them. “If you are a technical guy you are looking for signs the market is bottoming here,” says Mr. Weisbrod.

The volatility is also in large part because of a larger amount of angst than normal, says Emma Rasiel, an associate professor of economics at Duke University in Durham, N.C.

“The markets are trading more on psychology,” says Ms. Rasiel, director of Duke’s Financial Education Partnership. “People are scared by what is happening.”

One measure of volatility is the VIX, a futures exchange index, sometimes called “the fear index.” During normal times, it trades at around 20. Recently, it has soared to over 48.

“That means people are panicking,” says Rasiel, referring to the price level on the VIX.

Another measure of volatility is the large spread between the highs and lows for the trading session. In August, there have been six days where the high separated the low for the day by more than 400 points. In the two years between July 2009 and July 2011, there were three such days.

Rasiel says a major reason for the overreaction by the markets is sharp losses many people have experienced in their portfolios. According to Moody’s Analytics, the stock market has lost $3 trillion in value since the peak in late April.

The losses are resulting in emotional decisions. Rasiel says “behavioral economics” has found the extent to which people hurt from losses is twice the enjoyment they get from gains. “So, there is some major misery going on here,” she says.

At the same time, Coleman says the wide swings are partly the result of the cloudy economic situation.

“The reality is that the data is continuing to show the economy has not grown as much as anticipated and is even slowing in some respects,” he says. “This increases the loud noises we are hearing from people who think we will see a double dip.”

Coleman thinks the markets will stabilize once it becomes clearer which direction the economy is going.

On Thursday, for example, new claims for unemployment came in lower than expected. This led some investors to wonder if the economy might not be as weak as anticipated. More information will come out on Friday when the Commerce Department reports on advance monthly (July) retail sales.

“One positive is that we know the Federal Reserve over the next few years will keep rates low,” he says. But, he adds, this also means that the Fed expects the economy to have weaker growth than expected. “The Fed is sending a signal – we’re worried about the economy too,” says Coleman.

In a recent article on Yahoo! Sports, reporter Eric Adelson writes that Mark Cuban, the owner of the Dallas Mavericks, blames computerized trading for the volatility. After the May 6, “flash crash” where the Dow fell 1,000 points in minutes because of computerized trading, Mr. Cuban wrote, “There will be another crash.”

There might be something to this, says Rasiel, since many of the computer programs use the same triggers for their trading. “It should not have an effect, but if you think about it, and if they all use the same triggers, it becomes like a self-fulfilling prophecy,” she says.

Monitor Intern Geoff Johnson in Boston contributed to this story.

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