David R. Henderson  

Ask What Changed

RIP Nathan Rosenberg... Why bubbles are so hard to spo...

Many people are trotting out their pet theories for why the stock market has crashed in the last week. Some of them may even be right. But there's one question we should ask of all of them: What changed?

Here's what Charley Hooper and I write in the chapter "Ask What Changed" in our book Making Great Decisions in Business and Life:

Have you ever had a conversation like this? You point out to a friend that the stock price of Hunky Chunky Potato Chip Company doubled in the last six months. Then your friend explains, "Yeah, that's because people love potato chips. Their love borders on addiction." Or you comment that far fewer people are attending Major League Baseball games this year, and your friend's explanation is that baseball is so boring.

Your friend explained nothing. If people love potato chips so much, didn't they love them last year too? Then why wasn't Hunky Chunky Potato Chip's stock just as high six months ago? If baseball is so boring, why were so many people attending last year? To explain a change in some variable, you have to point to something else that changed, not to something that stayed the same. What did change? Are people disgruntled over the baseball strike? Did ticket prices go up? Have people fallen in love with another sport? Something caused the change you're observing. The trick is to identify the key elements that changed and not the fundamental elements that didn't. We doubt that baseball has gotten less exciting or that people just recently discovered potato chips. It is entirely possible that the popularity of potato chips and baseball ebbs and flows, but then the variable that changed is the popularity itself.

Why did the stock market fall? Could it be something that happened in China? Absolutely. Could it be a change in sentiment? Absolutely. But it has to be a change.

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COMMENTS (6 to date)
roystgnr writes:

It has to be a change, but it can be much more subtle than "a change" connotes; e.g. it could be a change in common knowledge of a change in common knowledge of common knowledge of a change. Stock markets are like a much more complicated real-world version of The Blue Eyes Puzzle.

Kevin Erdmann writes:

I think discussions of complex changes - like the recent stock market move or changes in currency exchange rates - are generally impossible to source. So, when something happens where the discussion is generally more or less about blame, it becomes a Hansonian topic, where the discussion is really a way for people to insert their biases without knowing that that is what they are doing.

It's the Chinese, it's speculators, it's computer trading, it was a bubble, etc. It usually comes down to the usual issues - xenophobia, anti-market bias, Ludditism, pessimism. Basically Bryan's four MOTRV categories, untethered to any falsifiable empirical evidence. So, you can't learn that much about the market through these discussions, but you learn a lot about the commentators.

Vivian Darkbloom writes:

What kind of "change", from one moment to the next, causes an avalanche?

ColoComment writes:

"What kind of "change", from one moment to the next, causes an avalanche?"

When an unstable layer of snow has built up and its cohesion to the [more stable] layer beneath is weak, it doesn't take much of a nudge, or change in the environment, to cause it to release and fall. A mere loud sound or small movement may serve as a trigger.

Nice metaphor.

Roger McKinney writes:

Yes, Vivian, that is the appropriate metaphor. A very light snowfall might cause an avalanche and people would say avalanches are random events.

I try to apply the ABCT to investing in the stock market and it has been clear for a year that the omens have been piling up for a major crash. Professionals have been following those omens. They include collapsing energy and commodity prices and over a year of trouble in China.

They also know that the first signs of trouble are record setting good news in the profit, sales, lending sectors. As the ABCT suggests, things look best just before the crash.

The fall in the Chinese markets by themselves would never have caused the avalanche, but it could easily have been the last snowflake.

Hazel Meade writes:

@Roger McKinney

I agree there have been warning signs from China for well over a year. I actually started moving to safer investments last summer. Of course, then the stock market kept performing better, so then I moved some of them back .... lol.

That said, I think the US stock market drop had more to do with Chinese problems reaching the threshold of popular awareness than with US fundamentals. Perhaps US stocks had gotten a bit overpriced, but we're not headed into a recession.

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