Cult classics have a nice way of putting complex modern problems in perspective. You may not find a better key to understanding the wild ups and downs of the stock market over the past two months than Douglas Adams’s seminal 1979 science-fiction tome, The Hitchhiker’s Guide to the Galaxy. The book features the tale of an advanced alien race—stick with us here—that builds a supercomputer for the sole purpose of generating an answer to the “Ultimate Question of Life, the Universe, and Everything.” After 7.5 million years, the computer spits out its answer: 42.
Only then does it become apparent that no one has any idea what the Ultimate Question was in the first place.
Bear that in mind as you watch policymakers search for the Answer to why U.S. stocks are currently caught in their most prolonged and intense period of volatility since the height of the financial crisis. Since the first week of August, the S&P 500 index has bounced between daily 2.5 percent gains and 2.5 percent losses with the steady frequency of a sine wave. The most-watched volatility statistic—the Chicago Board Options Exchange Market Volatility Index, or VIX—has touched a new post-recession high.
All of that movement is liquid adrenaline for day traders, who can score big by betting on market swings before they happen. It’s mildly terrifying for average investors, though, because the ups and downs don’t make any intuitive sense. Headlines grasping at explanations for the swings don’t help. Why would stocks fall on a Monday, reportedly over renewed fears of a Greek default, then leap on Tuesday, when the fears hadn’t really changed at all?
Ace financial blogger Felix Salmon, of Reuters, took a blowtorch to such explanations last week, in the bluntly titled post, “There’s no reason why stocks are down today.” Salmon criticized analysts and news reporters for attempting to find “some spurious reason” every day (such as a reaction to a Federal Reserve Board announcement or to European leaders’ latest statements about the Continent’s debt crisis) for why the market behaved as it did. “This kind of thing matters,” he wrote (italics his), “because when news organizations run enormous headlines about intraday movements in the stock market, that’s likely to panic the population as a whole.”
Which brings us to the “42” problem. Journalists, traders, and, worst of all, policymakers are treating every crest and trough of the stock market as the Answer to the question of whether the U.S. economy is regaining steam or headed back into recession.
But there’s no evidence that that’s the Question the market is answering for us.
In truth, despite decades of research, economists remain unable to predict the size and duration of big stock-market swings. “We still don’t have a clear, mathematical understanding of volatility’s source,” Yale economist Robert J. Shiller cautioned in a New York Times column in September. The best way to understand volatility, he said, was through John Maynard Keynes’s famous comparison of the stock market to a newspaper beauty contest in which readers look at 100 photographs and attempt to guess which six other readers will find most attractive. In the market today, Shiller wrote, “people are trying to guess whether other investors are thinking that yet others are thinking that the stock market is ‘dangerous,’ or whether it is instead a great time to invest.”
The Great Question, in other words, isn’t, “Is the economy getting better?” Instead, it might be, “What do people think other people think about whether the market will get better?”
That’s a huge distinction, especially for federal lawmakers who continue to bicker while the economy stalls. So instead of parsing every market movement in a way that bolsters ideological policy positions—be they cutting federal spending or increasing tax rates on the wealthy—leaders in Washington should step back and reconsider what all this volatility might actually be telling them.
Here’s one possibility: The U.S. and global economies are really, really fragile right now; the most important determinant of growth is what political leaders do both here and abroad; and political leaders seem disorganized and befuddled. If that’s the case, then the Question that the market is asking—and answering, with its lurching gains and losses—is, “Will anyone set aside politics and work to rescue the recovery?”
It’s possible, of course, that the market is asking some other question. It would be great if we knew, for sure, what it was. In The Hitchhiker’s Guide, the aliens build a second computer, even more powerful than the first, which takes 10 million years to generate the Question to which “42” is the answer.
Policymakers today don’t have that long. They should focus on growth now—because it’s the best answer to almost any question that the market may be throwing at us.
This article appears in the Oct. 1, 2011, edition of National Journal.