Why the Market Moves

The stock market hates uncertainty. More to the point, investors hate uncertainty. Not knowing what will happen next is what drives the stock market to react to events with a bipolar flair.

But when you think about it, we actually have a solid understanding of the numerous bad things that can happen to companies and the stock market. Just because we can count the ways, however, doesn’t mean they will fail to surprise us when they occur. We can identify all the risks in advance, but that’s only half the battle.

From a broad perspective, the risks to the stock market boil down to two simple things: people and nature. Both can be unpredictable. Let’s talk about each of them.

For people, the problem – and opportunity – lies in our curiosity, fear, power, and greed.

Government officials wage wars or introduce policies that impact spending and taxation. They can inject instability by allowing or creating debt bubbles.

We have a Federal Reserve board comprised of 12 human voting members, who decide on the path of interest rates. Interest rates are like gravity, weighing down or easing up on everything in the economy. The Federal Reserve can stoke or smother inflation through its interest rate decisions.

Finally, people innovate. Entrepreneurs dream up new technologies and found new businesses to capitalize on the opportunities they see. They find new ways to build products and offer services better, faster, or cheaper. This competitive nature can be amazing, but it also destroys more stagnant businesses in its wake.

In short, people drive uncertainty.

What about nature?

Bugs are ever-present. That includes pests that in large numbers can ruin crops. It also includes diseases that spread among humans and can cause severe illnesses and death. These, in turn, have economic implications.

Weather is another aspect of nature. Mother Nature can be fickle. She unleashes droughts, floods, hail, and extreme temperatures. These weather events infiltrate our lives and our economies.

And lastly, I’ll lump “outer space” into nature. Things can come flying at us out of seemingly nowhere, such as a meteor crash. If a large enough meteor hit Earth, it could cause an economic crisis. In addition, there are solar storms and asteroids, not to mention deep-space radiation. Oh, and for good measure, we’ll throw in an alien attack as a risk. Why not?

In short, nature drives uncertainty.

So if we can catalog the bad things and the associated uncertainty they can cause, why does the stock market have a long and consistent history of overreacting to those known events? It’s the timing and severity that produce uncertainty.

To be a long-term investor, you must be an optimist. If you’re an apocalyptic, convinced the world is coming to an end, there would be no reason to care about or plan for the future. If everyone took that stance, the stock market could not exist.

As a result, investors’ base case scenario – and appropriately so – is that the future will be good. But that confidence comes in varying degrees. So, any time an event threatens that future – be it weather, disease, inflation, or an alien – some portion of investors lose faith in the future and sell stocks to avoid the expected onslaught, which causes the market to fall.

Fortunately, the optimists have triumphed over time, buying stocks in anticipation of the world living to fight another day. As a result, the stock market lurches forward.

This process recurs time and time again, and so it must be. Humans and nature will always be unpredictable.