Giovanni Pagliardi, ESSEC Research Fellow, publishes a paper with Prof. Francois Longin that sheds light on the assumptions and dark areas of finance, and provides research that can positively impact business and society. In the first of a two-part article, he advocates transparency and links findings to the wider effects on businesses and people.
What is the research paper all about?
The Paper we have published is called Return Volume Relationship in the tails: an analysis based on extreme value theory in the US market. What are tails? Well, if we look at a typical graph of stock market activity for a given day, for example, “tails” is the word we use to describe the distribution of stock market returns either to the left or right of this graph. On the left, the tails can be considered as “the worst returns”, for example when the return is a minus figure; and these minus return figures are usually associated with crashes. On the other hand, we have “best returns”, which appear on the right-hand side of the graph; for example +5% on your investment. These plus figures, then, are usually associated with good results and even market boom.
When we look at these tails – either left or right – we talk of “extreme events”: that is, crashes or booms.
What are your research results in a nutshell?
We found what we call the extreme correlation – that is, correlation between returns and volumes – in these tails was pretty low and much lower than expected. And this is in fact in opposition to the usual tendency for people to believe in the Wall Street adage that it takes volume to move prices: that is, when there is a market crash and a market boom, they are associated with very big volumes in the market – selling and buying stocks. Actually, what our studies revealed was that the correlation between returns and volumes is much lower. Meaning that you might indeed associate very big volumes with crashes and booms, but you might also associate very low volumes with crashes and booms too. So we cannot categorically adhere to the Wall Street adage that says it takes volume to move prices. Sometimes, or even often, we can associate crashes and booms with relatively smaller volumes.
Crashes can occur through panic – but are there any other factors that cause market crash?
On the one hand, we have the assumption that panic selling leading to market crash is often caused by events such as a drop in industrial production, a scare, and war. However, attempting to prove in practice what the Gennotte and Leland model proposes as theory – that most often market crashes and not necessarily associated with very big volumes – the empiric results of our paper through our work of mapping stock market results and using statistical analyses found that dramatic events as causes for market crash are not necessarily always the cause.
What we found to support their theory is that very often we observe asymmetrical information between market participants, meaning that person A doesn’t know why person B is selling; so person A might just see on his computer screen that the market is performing at minus 1% and he doesn’t know why – there’s no news. The risk is that this leads to a mechanism which can cause further selling of stock and shares and in the end this may lead to a stock market crash.
But even without news, and because of what we call positive feedback strategies (such as algorithmic trading on computers that occurs every second or millisecond or so) crashes can happen. For example, if a bank or speculator, using algorithmic trading on a computer, wanted to start selling at a high rate and we saw the impact of this on our screen – a market performance that drops to minus 1% – we might think that these initial sales are due to someone who is more informed than us and we start selling accordingly. And then someone else does the same, and another person copies, and so on, and the market will end up at minus 4%.
So we can associate big market crashes with absolutely no big news. This begs the question: why should a market fall by 7% if nothing happened? This is what occurred in 1987, with a crash of about 20% in one day and it’s still something of a puzzle and an enigma for academics: because on that day almost nothing of any major consequence happened in the world.
What is the link with business and society?
When you run a business, you can decide whether to go on the stock market or not. When a firm goes onto the stock market it has to take into account that it is exposed to great opportunities to achieve funding and returns, but also more dangerous processes because a business is, essentially, stock. Moreover, we tend to think of the stock market as something abstract, but the stock market is made up of firms. Stocks are firms – like Apple, Microsoft, General Motors, and General Electric that sell products in the world – and if they lose on average in one day 20% of their value, this has a great impact on their business, their company, and the people who work for them. Moreover, in the end run, it’s the people who invested in the firm that are losing their money.
And this constitutes the link with society: today, many people invest their savings, either in banks or stocks or something else. So most of us have a little or large amount of money invested in something on the stock market. The stock market therefore has a big impact on everybody. It’s not just watching TV and seeing as in 1987 a loss of 20% in one day on the Standard & Poor market. It indeed lost 20% but it concretely means that if a person invested the €100,000 he had saved over the last twenty years, he would lose €20,000 in one day on the stock market – and this for no apparent reason. It affects everybody who invests on the stock market and who saved money thanks to their work and effort. Transparency, communication and guidelines for behaviour are extremely important in terms of speculation as the situation with Greece and other countries has shown.
In the light of your research, what would you like to see occur?
More transparency – this is the main issue today. Transparency is essential to avoid situations where people who are not big traders, but like you and me, become affected by the negative behaviour of other people who aren’t very transparent. If I were to use a metaphor, I’d liken our research to light, a torch: something that really sheds light on something which appears to be dark. Where there is shadow, there is light.
From an interview with Giovanni Pagliardi. Written and edited by Tom Gamble, the Council on Business & Society, 2016.
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