Over at the Volokh Conspiracy, Ilya Somin and Eric Posner have been having a spirited debate about the recent failure of the "Paulson Plan" to pass Congress. Prof. Somin is of the opinion that yesterday's drop in the markets provides no information about the intrinsic value of such a bailout - Paulson proposed to transfer lots of money from taxpayers to shareholders: that failed; shareholders were disappointed.
Prof. Posner believes, instead, that the markets fell because the plan was good for everyone (taxpayers and shareholders) and that, consequently, when it failed, the markets were signaling their overall fear of the future, not their specific fear that they'll be unable to rob taxpayers.
David Post weighs in with his opinion that the information in the market is not sufficient to tell the two apart:
I don't see any way to distinguish between those two hypotheses without asking a (large) number of yesterday's traders what they had in their heads, and why they made the trades they made (and even that, of course, is deeply problematical, given the enormous difficulties of getting any reliable information from surveys of that kind).
His point here, of course, is good. In the best of circumstances, it's impossible to tell what the market "means" by its movement - if such a question has any validity, at all. But, I think, there are at least two other hypotheses that can't be ruled out with this data.
First, it's quite possible that these movements are largely random. People are making individual decisions not based entirely upon news, but more upon other conditions in their portfolios, expectations of what everyone else is going to do, raw emotions. If these are the causes, no conclusion may be drawn, in any case.
Second, investors abhor risk that they know that they don't understand. When a company announces that it's going to restate previous earnings, it often causes a drop in the stock well out of proportion to the eventual restatement. It reminds investors that they really have no idea of the actual underlying information about this security, and causes them to sell.
A similar problem is the event that started this whole mess - it turned out that subprime mortgages that were thought to have a pretty low default rate (say, 4%) will have a larger default rate. How much larger? No one knows. It's hard to imagine that, even in a Great Depression scenario, it'll be more than 20% (and that is really in an unmitigated and highly unlikely disaster). When investors realized they had no idea what the underlying risk of default was, they fled these investments, causing a precipitous drop in price, far beyond even the worst estimates of the actual losses.
It is not unheard of for companies to rise on bad news - because the uncertainty about their fate has been eliminated. It is quite possible that the market had been expecting that the Paulson Plan would pass for the past week. It's also possible that the consensus was that it was worth than nothing - but, that consensus was priced into the securities, already. When Congress failed to pass the Paulson Plan, it raised the specter that something even worse would happen, and this possibility is what the markets were responding to.
As Prof. Post notes, we have no way to distinguish between any of these hypotheses. I thought it was worth noting, though, that there is even an argument that the market went down because it thinks the Paulson Plan that didn't pass is worse than doing nothing.
Of course, the market went up, today: What does that tell us of the market consensus of what we should do?