What Moves the Stock Market?

With the stock market’s unexpected boom toward the end of 2014, what better way to ring in the new year than to reexamine that age-old question: What drives stock returns? Is it earnings’ growth fundamentals or short-term momentum swings in investor behavior?

The answer matters because most forecasters expect the economy to grow faster this year than in 2014, which argues for another good year for the market.

But many traders will tell you that investors’ emotions matter a lot more. One emotional strategy has long attracted interest among financial economists: “momentum trading,” or buying as long as the market is going up, or short-selling when the market is headed in the other direction. Various studies have suggested that, at least for professional money managers who can buy and sell stocks in volume and keep their transaction costs low, this strategy can generate superior returns, even adjusted for the risk of periodic crashes. A December study by three economists at the Federal Reserve Bank of Chicago confirms this result.

The economists came to this conclusion by looking at stock returns during the “Victorian era,” in the second half of the 19th century, as well as from 1927 and 2012. Momentum trading paid off in both periods. This was true even when, according to the authors, the risk of a stock market crash seemed high: Investors poured money in and wanted it invested, so they kept pushing up prices until bubbles burst.

Does that mean that individual investors should try to be momentum investors too? No. Even with low brokerage commissions, the trading costs would eat away any superior returns. In addition, many investors don’t have stomach to bear the costs of those crashes.

So what’s the individual investor to do? Stick to the standard advice: Don’t try to time the market. If you have cash to invest, do it gradually and consistently (the “dollar cost” average way to invest), adjust your mix of stocks and bonds to your age (the older you are, the less of the former and more of the latter), and put your stock money in index funds.

It’s hard to do, but it’s best to sit back and not let emotional reactions to daily news tempt you to move your money around too much.

Let’s also hope the world will be a better place this year than the one before.