In early August this year, many stock markets around the world saw a sharp drop for one or two days, followed by a gradual recovery in the following days. In the stock market, although stocks are usually volatile, such days are not common. Many investors believe that some events have occurred that have completely changed the valuations of assets listed on these exchanges, but in fact, there are no significant or decisive factors that can justify such a sudden change. For the S&P 500 index, it fell by nearly 7% between August 1 and 5. But what caused all this in the US and other markets?
The first thing to mention is the employment survey. Bureau of Labor Statistics The first few days of the month in the United States were dominated by reports of new jobs and unemployment data. Data released on July 30 showed that the unemployment rate for the month was 4.3%, up 0.2 percentage points from the previous month and well above the level of 3.5% a year ago, which once again raised fears of a recession. This is not surprising: the high-interest monetary policy of the Federal Reserve has affected consumption and corporate finances, leading to a series of layoffs. Nevertheless, 4.3% is far from the alarming level, as it is even lower than the 5.5% that is said to be the long-term average unemployment rate. Furthermore, the market also welcomes other increases in the unemployment rate, as it means that the Federal Reserve will start to reduce interest rates, which has a positive impact on the value of assets traded on the stock exchange, especially bonds.
The previous situation did not seem so catastrophic, which leads to the issue of behavioral biases in the stock market, which is part of the branch of behavioral finance, and we will see two biases that occur in this market situation. First, it is important to define what behavioral biases are; these are simplifications made by the human mind that require automatic responses. As Nobel Prize winner Professor Daniel Kahneman said, getting answers quickly is not all bad, because it helps us simplify tasks and save time, but not all tasks can be done “automatically”.
With that clear, let’s look at the first one: rationality bias. It is often assumed that individuals are rational, that is, they analyze situations without bias based on data. Similarly, it is assumed that in the stock market, individuals are educated and experienced, and therefore less likely to be swayed by their emotions. However, this objective was not fully realized in early August. Because? A data problem: the US economy grew 2.8% in the second quarter, beating expectations by 0.7%. This economic growth number was very strong despite an increase in the unemployment rate and a sign that economic activity may be slowing down. Although the unemployment rate data was not very optimistic, it would be unreasonable to consider a recession immediately after the data exceeded expectations by a large margin.
Related to this, we have a second bias: representativeness, also known as overreaction bias. This is defined as drawing conclusions from data that do not make sense or represent the situation. The negative unemployment data is for a single month and is analyzed in isolation, so being able to give a recession forecast with so few variables and such a short time frame is not representative. We are not making such an assertion because of a few sudden data points, and even so, this bias is not discriminatory: it was completely hasty for analysts to comment to the media that the Fed should have made an emergency rate cut in the same week.
In conclusion, market panic and declines do not always have rational explanations or explanations based on economic fundamentals, but rather investor psychology plays a decisive role in short-term results. The above is proven based on the results of the next few days: the S&P 500 recovered its losses within a few days and is moving in a positive direction in August; this would not have happened if the panic was rational.
