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The Stock Market and ... Saddam Hussein?

Question: What's the most pervasive of all investment myths?

Answer: The notion that "news events" drive the stock market's turns and trends.

This myth is retold by the talking heads and in the financial section of the newspapers virtually every business day.

Of course, no one who expects silly things from the media remains disappointed for very long. Yet the point is, too few people do realize it's silly when they read headlines that claim, "Greenspan Said This -- the Stock Market Did That."

What's more, the myth usually casts a spell in proportion to the size of the news event -- namely, the bigger the stronger. Sunday, Monday, and even Tuesday of this week provided a perfect example, after the announced capture of Saddam Hussein.

It's easy enough to provide a chronology of the myth at work: consider this series of headlines.

--Hussein's Capture Seen Boosting U.S. Stock Market (Sunday, Dec. 14, 6:42 p.m. ET)

--Stocks Rise in Morning Trading on Hussein News (Monday, Dec. 15, 10:18 a.m. ET)

--Stock Indexes Continue Rally at Midday on Hussein Capture (Monday, Dec. 15, 12:21 p.m. ET) 

--Stocks Close Sharply Lower Despite Hussein's Capture (Monday, Dec. 15, 4:59 p.m. ET)

For the sake of fairness I plucked each of these from the same wire service, yet they represent what all the news outlets were saying. Note that the first headline was on Sunday evening, some 15 hours before the U.S. stock indexes opened for trading; thus the media reported speculation even before they reported news. And the three headlines from Monday don't begin to reflect what really happened; index prices saw a very brief rise at the open, only to trade lower the rest of the session.

Still, Saddam climbed from a hole in the dirt into more than a day's worth of financial stories. There were copious numbers of similar remarks about price action in currencies, Treasury bonds, precious metals, and energy markets; it didn't matter if prices went up, down or sideways. Investors were led to believe that whatever happened, it happened "because of" Saddam's capture.

It wasn't over by Tuesday, either. An 8:04 a.m. ET news report that day claimed, "Tokyo stocks dropped as investors locked in profits, disappointed that the capture of Saddam Hussein failed to bolster U.S. share prices." Naturally one doubts that Mr. Hussein's U.S. captors allowed him to read this piece of news. No one wants a deposed dictator to sit around believing that he was still moving markets on Tuesday due to the fact that news of his capture failed to move them on Monday.

Not that Saddam's interrogators are without a way to knock him down a peg. It's conceivable that they forced him to read this comparison to a certain other bad guy still-at-large, who, according to the lead sentence in a Reuters news story, may have even more power to move the markets:

"The capture of former Iraqi leader Saddam Hussein gave an initial boost to stock markets worldwide on Monday, leading some analysts to believe that a bigger rally would occur if the United States reels in Osama bin Laden..."

Alas, by the end of Tuesday's trading, the financial media had redefined this defining news event to just a "diversion." It seems, well, that "investors returned their attention to economic news." Like the cold vapor that comes and goes when you open and close an icebox door, the connection from the news to the financial markets vanished -- until next time.

I trust that you'll take more from this than a moment's amusement. The issue is not the newsworthiness of Saddam's capture; indeed, it's one of the top stories of the year. There is no doubt about its relevance to international affairs, to the U.S. military forces in Iraq, and to the desire for justice among Saddam's innumerable victims.

But it's not relevant to the stock market.

On most any given day, the media's cited "reason" for price moves in the financial markets won't withstand close scrutiny. If you like things simple you can do the analysis yourself with nothing more than price charts. If you want more rigorous proof you can read academic research, such as the study published in the Journal of Portfolio Management in 1989, titled "What Moves Stock Prices?"

It was written by three big-name economists, including former Treasury Secretary and current Harvard President, Lawrence Summers. The study is full of statistics, complex language, and even more complex math formulas. Yet I'll condense their answer to what moves stock index prices into three words, namely "Not the news." They conclude by saying that "the information that the press cites as the cause of the market move is not particularly important."

So in the face of abundant evidence to the contrary, why does the media (and much of Wall Street) still embrace the myth? In the case of Saddam's capture, part of the answer is that one myth perpetuates another. "News moves the markets" flows from a notion expressed this past Monday on the Money Page of USA Today: "Having the former dictator in custody eliminates a major uncertainty haunting investors..."

It's the "investors don't like uncertainty" myth -- and it sounds practical until you think about it, oh, for about 12 seconds. It assumes that something resembling "certainty" is normal in politics, international affairs, economics, and finance.

I mean, wasn't it around four years ago that the markets were rising, that the economy was raging, that international affairs were stable, and that a popular two-term president dominated the political scene?

Wasn't all the "certainty" of that moment in time consistent with U.S. history for the past 50 years?

I trust that you shake your head at the folly of the suggestion. Just give a moment's thought to the time since WWII. National leaders were assassinated. The international landscape featured a 40-year Cold War, dozens of hot wars, and vast nuclear arsenals. Multiple recessions. The S&L crisis. One president was murdered, another resigned his office, another took a bullet in the chest. Stocks were nowhere after an entire decade (the 1970s). This is off the top of my head, but I could go on. So could you.

As for four years ago -- when things were certain -- we know the reward that awaited investors who acted on their "certainty:" the S&P 500 lost nearly half its value, while the Nasdaq Composite fell 80 percent.

Yet nearly every day, the financial press repeats the myth that a possible news event creates certainties (or uncertainties) in the stock market; in turn, one myth is supposed to solve another, as the quote from USA Today suggested. It adds up to irrational financial analysis, fiction disguised as logic, and a vulgar understanding of history.

Using the news to make financial decisions is like relying on the rear view mirror at a fork in the road. Investors who do so are doomed to react to events, instead of anticipating them.

Seek out and learn to use the tools of technical analysis, particularly pattern analysis. Become intimate with the market you put your money in: in time you'll understand its behavior and the "language" it speaks.

Saddam Hussein cannot tell you the S&P 500's future -- the S&P 500 can.

Robert Folsom is a financial writer and editor for Elliott Wave International, a financial analysis company. He has covered politics, popular culture, economics and the financial markets for 16 years, and today writes EWI's popular Market Watch column. Robert earned his degree in political science from Columbia University in 1985.

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