John Irons's Blog


Economic News, Data and Analysis

A Standing Ovation for the Stock Market

Clap. Photo/Graphic: J. S. Irons.Look
ma! No hands!

The roller coaster ride ride called the stock market is back up today.
The Dow Jones Average was up 4.6% Tuesday after a 7.2% drop (the 12th largest
single day loss, and the largest point drop ever)
on Monday. Speculation abounds, as always, as to why the market jumps so

Yesterday, after the market closed, a parade of commentators spoke of
the market’s apparent “correction” and speculated about its future. Some
thought that the market was over-valued and that the drop was a natural
“re-alignment” of prices to fundamentals with the Asian Markets acting
as a trigger. Some though that the drop would continue, some not. With
the rebound today, I’d guess that just about half of the commentators were
proven wrong.

Ok. Fine. So like a great baseball player, the market sometimes needs
to adjust itself. The timing and the magnitude of these adjustments are
easy to explain after the fact, but hard to predict beforehand. One side
of the issue that has been neglected is the reason for why these adjustments
always seem to happen during the course of a single day of trading. Why
not a week, or a month?

Part of the answer, surprisingly, can be seen by thinking back to the
last time you saw a good concert.

Standing Ovation

The concert has just come to an end and the applause begins. “Wow”,
you think, “That was a great performance.” The applause gets louder, you
hear “bravo!” from someone in a seat in front of you. More applause…
what do you do? Keep clapping? Stop? Or rise from you chair for a standing

If you stand up for the ovation, what happens if you are the only one
who thought the performance was good enough to warrant an ovation? You
might end up the only one standing and looking foolish – not all concerts
end in an ovation. On the other hand, you could just wait in your seat
clapping to see if anyone else is willing to stand up, then join them if
they do. Also, if a standing ovation does occur, you don’t really want
to be the only one sitting.

Now think of an auditorium full of people just like you who might like
to stand (and who would if others were) but are not willing to take a chance
of being the first (and only) one standing. What happens? Typically one
person, or a small group, is finally bold enough to make the first move
and stand, then, very quickly, others in the auditorium follow and do the
same, followed by more and more (including those who didn’t necessarily
like the show but feel too embarrassed to be the only ones still sitting)
and in only a few seconds the entire auditorium is standing.

Information cascades

The parallel with stock market crashes (and rallies) should be obvious.
The end of the concert is like the opening bell on a day in which many
of the participants think stock prices are over-valued. A normal amount
of trading follows at reasonable prices- nothing too extreme until someone
or some small group “stands up” and a sell-off starts. Like the people
who liked the concert, the ovation rapidly encompasses the entire audience
and the market participants are selling like crazy.

No one wants to be the first and only one to start selling since the
market is still rising, but once the cascade begins, no one wants to be
the last to sell. The result is the one-day crash. The same happens in
the one day boom – no one wants to be the only person to by in a falling
market, but one things pick up, no one wants to be left out.

The parallel can be expanded by seeding the audience and the market
with people with better, or different, information. Say you are at your
first Jazz concert and that you know very little about both the music as
well as the ovation habits of typical Jazz audiences. In this case you
are more likely to be a follower and to do what ever the better informed
or more experienced people in the audience do. If they liked the performance,
and stand you will gather that it was a high quality show and that standing
is appropriate, and thus you will be more likely to stand.

In the market case, one a sell-off starts people may be thinking “hey,
maybe they know something I don’t” and will follow the trend, since the
information generated by some trades helps to inform others about what’s
going on. Alternatively, the selling by others may confirm your beliefs
and give you more confidence to act on them.


The above ovation analysis began by looking at “micromotives” – the
actions of a single individual or investor in a larger group – and wound
up explaining “macrobehavior” – a standing ovation or market crash.

This style analysis is certainly nothing new to economics – it’s roots
go at least all the way back to Adam Smith. It is not, however, an easy
process to move from a description of individuals within a group to the
behavior of the group as a whole – especially if there are important interactions
between the individuals. If we wish to further complicate things by introducing
any kind of informational or other kinds of heterogeneity into the population,
it becomes very difficult to understand the macrobehavior of the system.

Computers are helping in this regard as it is becoming possible to simulate
a large group of interacting artificial computer generated “people” to
see what happens in, say, a market or an auditorium. The field of “Computational
Economics” is developing along these lines.

Elvis has left the building, Elvis has left the building.

I think everyone has had the experience of standing too long at the
end of an ovation – the feet start to tire, the hands get sore from too
much clapping. So now that a standing ovation has started, or a crash has
taken hold, how do we stop it? What we need is for some common signal to
coordinate our actions.

It was hoped that the circuit breakers would be able to provide this
signal and the worst of the crashes would be avoided. The fact that the
first circuit breaker did not stop things on monday means we need a better
signal (although, what would have happened without them is still an open

It does appear that turing on the house lights and ending the day at
the market does help, since, as usual, a large rebound followed the cascade.

Or maybe it was just a good night’s sleep.

See Also:


October 97. Not the biggest
drop or gain in history.

The market has seen considerable swings in the past few days; however,
despite the claims of many media outlets, the DJIA has not been
down and up by record amounts. 

It is true is that the absolute point gain has bounced around
by record amounts, but… well… so what? What really matters is the percentage
gain in the market. 

Today the market was up by nearly 4% after loosing around 6% on monday.
Compare this to the 1987 crash of 22.6% and the following rally the day
after when the market rose by nearly 6%. 

In point terms, a crash of the 1987 magnitude would have meant around
a 2,000 point drop in the dow today. 

The “crash” on monday was in fact only the 12th largest crash in history.
The only reason it seems so big is that the absolute number of the drop
seems “large” – but since the overall level of the market is so high, the
percentage drop — which is what we really care about — is not quite as


Points %Change

October 19 

October 20



October 27 

October 28






Filed under: Finance

Finance professors win the 1997 Nobel

Robert C. Merton of Harvard University and Myron S. Scholes
of Stanford University have been awarded the 1997 Nobel Prize in economics
“for a new method to determine the value of derivatives.”  They join
the list of past winners of the prize.

The late Fischer Black was cited along with the two winners as contributing
to the work for which the nobel was awarded. As the award cannot be awarded
posthumous he was not on the official list of winners. However I think
it is safe to say that the award goes to the Black-Merton-Scholes trio.

For an overview of the the research leading to the Nobel see the prize
. The Nobel site also has further
on their work.


The Prize a surprise?

Nobel Medal

Last week this space was devoted to getting predictions
about the winner of the prize. Of 35 responses none were for Merton or
Scholes. The Internet
for Nobel Laureate in Economics sponsored by the European JOE
received over 500 votes and only three (2 for Scholes and 1 for Merton)
were for the actual winner. The leader in both informal polls was A. Sen.

One reason that the award may have been somewhat a surprise was that
the Nobel prize was awarded in 1990 to three Marlowvitz, Miller, and Sharpe
for their “pioneering work in the theory of financial economics”. In the
past the Nobel committee has tended to give the award to a diverse range
of fields within economics and only rarely repeating fields in such a short
period of time.

As for Merton’s reaction… “I was speechless”.

“Value of Derivatives”

The winners were cited as having solved a pricing problem that had long
plagued economic theory. The specific work sited by the committee was a
1973 paper by Fischer Black and Myron Scholes which published “the famous
option pricing formula that now bears their name” (c.f. 1973, Journal of
Political Economy). Also in 1973, Robert Merton published articles with
the formula and various extensions (1973, Bell J., Econometrica).

From the announcement: “The option-pricing formula was the solution
of a more than seventy-year old problem. As such, this is, of course, an
important scientific achievement. The main importance of Black, Merton
and Scholes´ contribution, however, refers to the theoretical and
practical significance of their method of analysis. It has been highly
influential in solving many economic problems. The scientific importance
extends to both the pricing of derivative securities and to valuation in
other areas.”


Best of luck to the two newest winners of the prize.


See Also:


Past Winners 


  1. R. Frisch, J. Tinbergen 

  2. “developed and applied dynamic models” 

  3. P. Samuelson

  4. “economic theory and… raising the level of analysis in economic science” 

  5. S. Kuznets

  6. “empirically founded interpretation of economic growth” 

  7. J. Hicks, K. Arrow 

  8. “general economic equilibrium theory and welfare theory” 

  9. W. Leontief 

  10. “development of the input-output method” 

  11. G. Myrdal, F. Von Hayek 

  12. “theory of money and economic fluctuations and… analysis of the interdependence
    of economic, social and institutional phenomena” 

  13. L. Kantorovich, T. Koopmans 

  14. “theory of optimum allocation of resources” 

  15. M. Friedman 

  16. “consumption analysis, monetary history and theory and… demonstration
    of the complexity of stabilization policy” 

  17. B. Ohlin, J. Meade 

  18. “theory of international trade and international capital 


  19. H. Simon 

  20. “decision-making process within economic organizations” 

  21. T. Schultz, A. Lewis 

  22. “economic development research” 

  23. L. Klein 

  24. “econometric models … analysis of economic fluctuations and economic

  25. J. Tobin

  26. “analysis of financial markets” 

  27. G. Stigler 

  28. “industrial structures, functioning of markets and causes and effects
    of public regulation” 

  29. G. Debreu 

  30. “new analytical methods… and… rigorous reformulation of the theory
    of general equilibrium” 

  31. R. Stone 

  32. “development of systems of national accounts” 

  33. F. Modigliani 

  34. “analyses of saving and of financial markets” 

  35. J. Buchanan 

  36. “contractual and constitutional bases for the theory of economic and
    political decision-making” 

  37. R. Solow 

  38. “contributions to the theory of economic growth” 

  39. M. Allais 

  40. “theory of markets and efficient utilization of resources” 

  41. T. Haavelmo 

  42. “probability theory foundations of econometrics and his analyses of
    simultaneous economic structures” 

  43. H. Marlowvitz, M. Miller, W. Sharpe 

  44. “pioneering work in the theory of financial economics” 

  45. R. Coase 

  46. “clarification of the significance of transaction costs and property
    rights for the institutional structure and functioning of the economy” 

  47. G. Becker 

  48. “extended the domain of microeconomic analysis to a wide range of human

  49. R. Fogel, D. North 

  50. “renewed research in economic history” 

  51. J. Harsanyi, J. Nash, R. Selten 

  52. “equilibria in the theory of non-cooperative games” 

  53. R. Lucas 

  54. “hypothesis of rational expectations, and thereby having transformed
    macroeconomic analysis” 

  55. J. Mirrlees, W. Vickrey 

  56. “economic theory of incentives under asymmetric information” 

  57. R. Merton, M. Scholes

  58. “for a new method to determine the value of derivatives”


Filed under: Economists

Yes, we can learn from our mistakes

Immediate policy response prevented 1987 from becoming another 1929.

The magnitude of the 1987 stock market crash was much more severe than
the 1929 crash – a drop of 22.6% versus 12.8%. The loss to investors amounted
to $500 billion. Over the four day period leading up to the October
19th crash the market fell by over 30%. By today’s level’s this represents
a 2,200 point drop in the Dow. However, while the 1929 crash is commonly
believed to have led to the Great Depression, the 1987 crash seemed to
have no lasting effect on the real economy.

Why not?

A good case can be made that quick policy action on the part of the
Federal Reserve and the Treasury deserves some of the credit. This stands
in stark contrast with monetary policy blunders that contributed to the
Great Depression.

Why does a crash matter anyway?

So investors lose some money in a crash – why should this matter for
the real– i.e. non-financial– economy? The problem arises when the drop
in the book value of of investments causes widespread bankruptcy and the
closing of doors. If financial houses were forced to close down, then the
availability of funding for investments would be reduced, hurting the ability
of firms to increase or continue production. As the ripple of financial
institution closings makes it way through the economy, firms producing
goods and services would eventually feel the bite of the reductions of
loan availability. In the 1930’s this meant a Depression.

The Policy Reaction

After the largest one day drop in the market in history, the Federal
Reserve took immediate steps to increase the supply of liquidity in the
market. The goal was to prevent bankruptcies, which would eventually hurt
the real economy, by making loans to the investors than were in danger
of running out of money. The strategy appeared to have worked, and the
Fed certainly earned it’s title of “lender of last resort”.

Policy makers themselves were also quick to respond. Alan Greenspan
in a statement said that “The Federal Reserve, consistent with its responsibilities
as the nation’s central bank, affirmed today its readiness to serve as
a source of liquidity to support the economic and financial system.” President
Reagan said
“…I think everyone is everyone is a little puzzled because…
All the business indices are up. There is nothing wrong with the economy.”

Still Learning

As the 1987 crash demonstrated, we are still learning. Since the crash,
a number of regulatory changes have been made to try to prevent another
severe “panic” drop in the market. Trading curbs and “circuit breakers”
to prevent mass sell-offs by computer traders have been instituted with
this goal in mind. So far, there has not been a crash of close to the same
magnitude as the 1987 or 1929 crashes – but only time will tell if they
will continue to prevent panics in the market.

For more on the Crash of 1987 see The Mining Co.’s 10th
anniversary special

See Also:

Filed under: Finance