That Uncertain Feeling.(The Talk of the Town)

American investors are frazzled. True, oil prices have fallen from their most vertiginous highs, the dollar is a bit stronger, and the stock market has actually risen over the past month. But none of those things have happened in a smooth and steady fashion. The stock market's "ascent," in particular, has come straight out of "Sybil." Since the beginning of July, there have been six days on which the S. & P. 500 has gone up or down by at least two per cent, and daily moves of more than one per cent--like the ones we saw at the start of last week--have come to seem practically routine. Precipitous falls in the market have frequently been followed immediately by sharp rallies, and vice versa. And, while some of these moves have been occasioned by real news, more often it's been impossible to tell just what made investors so damn exuberant or so gloomy.

Not that long ago, stock-market volatility appeared to be a thing of the past; between the end of 2003 and the end of 2006 there were only two days with moves of two per cent. But, ever since the credit crisis began, big moves have become common. The conventional explanation for this is "uncertainty": investors' sense of what the future holds is in constant flux, so stock prices are, too. But, in the dearth of new news, you might expect uncertainty to result in tentative oscillations, rather than in the huge waves of buying and selling that we've been seeing. In this market, the same traders who on Tuesday seem convinced that the apocalypse is nigh are, on Wednesday, just as sure that we've weathered the storm. If investors are unsure about tomorrow, why are they acting so certain about today?

Much of what's happening is a function of what economists call "herding." In conditions of uncertainty, humans, like other animals, herd together for protection. In unstable markets, this leads to trend-following: buy when others buy, sell when they sell. Many studies have found that mutual-fund managers herd, for a couple of important reasons. First, herding offers money managers the reassurance that their performance, whether good or bad, won't diverge too much from the norm. It also gives them a chance to piggyback on the knowledge of their competitors. That's why, when a stock starts to rise, traders often assume that there must be a good reason, and therefore buy in order not to miss the party. This can create a feedback loop: as more people buy the stock, the more certain others become that there must be a good reason to do so (even if they don't know what that is). And these feedback loops have been accentuated by the spread of quantitative-trading strategies that explicitly aim at riding the herd effect. These strategies can magnify trends instead of countering them. The result is that an individual stock can move up or down ten per cent on a day with no real news.

Uncertainty also ...