Market Movements and Information Cascades
Major US indexes have risen to record highs today in response to a positive outlook triggered by rising earnings and anticipation of the central bank rising rates in Europe. The Dow climbed nearly 70 basis points today to close at a record high of 17555, recording a gain of 5.9% since the beginning of the year.
While long-term investors may be excited at the prospect of rising dividends and the increasing value of US corporations, day traders have a much different outlook regarding their security selection. On a daily basis, stocks move based off of investors expectations regarding future performance rather than any increase in real value. This prompts day traders to spend much of their time gauging the attitude of other investors rather than evaluating future valuations. Regardless of whether or not a company will experience cost advantages in the future, if investors have a positive outlook on a company the price of the stock will reflect it today.
This interestingly relates to a key concept that we recently covered in HW 6: the information cascade. An information cascade occurs when somebody’s decision is influenced by the decision of others; in the example we discussed in class an information cascade occurs when the third person picking a marble out of a bag will predict that the bag is blue dominant regardless of what they draw so long as the first two players draw blue marbles.
The same idea applies to the way that day traders tend to select stocks; rather then choosing to invest in the companies that they think will experience long term growth, they invest in the companies that other investors think will experience long term growth. These are the companies that will move and the day traders will make money off of the momentum. Rather then reading this article and being excited about the prospect of higher future dividends and the potential for realizing capital gains in the long-term, day traders will read this article and then try to determine which companies other investors are most excited about. Information cascades are also the reason behind the current equity bubble, characterized by indexes experience much higher growth than GDP.
Source: http://online.wsj.com/articles/u-s-stock-futures-edge-lower-1415279918