The paper is worth reading because it helps us understand "large movements in prices unaccompanied by significant news about fundamentals".
There are hundreds of learned papers and books on why markets drop precipitously. Recalling how the Nobel-winning physicist Richard Feynman had helped explain the Columbia disaster in 1986, in the last few days, I have read more than a dozen research papers to see whether economists would be of any help.
But it turns out that while they are quite good at providing crash-specific explanations, they perform quite poorly when it comes to generalised explanations. Chance, necessity, luck, panic -- all very human things -- play a dominant role.
A 1999 paper* by Harrison Hong of the Stanford Business School and Jeremy C Stein of the Harvard Business School brought this out very clearly. They developed the theory which says that basically it is the existence of two views -- optimistic and pessimistic or bulls and bears -- that causes all the problems.
"Because of short-sales constraints, bearish investors do not initially participate in the market and their information is not revealed in prices. However, if other, previously bullish investors have a change of heart and bail out, the originally-more-bearish group may become the marginal 'support buyers' and hence more will be learned about their signals."
If you think about it, this is what we are being told to do now, namely, buy when the prices are down. And, indeed, this is what has been happening since Wednesday. (But, if I may add, no one has ever said "sell when the prices are up!")
Be that as it may, Hong and Stein said that the greatest plus point about market falls is that the "accumulated hidden information tends to come out." They are absolutely right. In the next few days we will learn of a lot of firms and industries that have been "performing" so well under the delicate manipulations of speculators.
It is worth reading their paper because it helps us understand "large movements in prices unaccompanied by significant news about fundamentals." In other words, they tell us why things change when there is no reason for them to.
Their paper also explains "negative skewness in the distribution of market returns and the increased correlation among stocks in a falling market."
Finally, it makes a prediction that "negative skewness will be most pronounced conditional on high trading volume."
In another paper**, in 2000, the same two authors, along with Joseph Chen, also of the Stanford Business School, had analysed the effects of skewed returns. They concluded that you can get negative skewness if there has been "an increase in trading volume relative to trend over the prior six months; and positive returns over the prior thirty-six months." Just look at the BSE's penny stocks and mid-caps and you get the picture.
Finally, there is the question of what central banks ought to do. The finance minister has said that the RBI will not be a problem, whatever he means by that. In this context, a paper*** by Frederic Mishkin, who is now with the US Fed, and Eugene White of Rutgers is worth reading.
They say that "financial instability is the key problem facing monetary policymakers and not stock market crashes, even if they reflect the possible bursting of a bubble. With a focus on financial stability rather than the stock market, the response of central banks to stock market fluctuations is more likely to be optimal and maintain support for the independence of the central bank."
The question now is: should the RBI cut rates as the US Fed has done, or should it sit tight?
*Differences of opinion, rational arbitrage and market crashes, NBER Working paper No.7376.
**Forecasting Crashes: Trading Volume, Past Returns, And Conditional Skewness In Stock Prices.
***US stock market crashed and aftermath: implications for monetary policy.