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Plummet, then rebound: Are markets crazy? Add to ...

The wild fluctuations in the stock market over the past week suggest that Mr. Market is alive and well.

When Benjamin Graham created the allegory of Mr. Market in his book The Intelligent Investor, he was trying to give investors an idea of how markets behaved – valuing stocks highly one day, only to change dramatically the next.

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That happens every trading day, but the past several days have been particularly wild. The S&P 500 fell to a one-month low on Monday after suffering its worst selloff of the year, only to bounce back in a three-day rally that has put its five-year high back in sight. Incredibly, the Dow Jones industrial average is now closing in on a new record high.

When were stocks priced correctly – during the selloff or the rebound?

For sure, there are reasons behind the volatility. Earlier in the week, investors were apparently fretting over concerns that the European debt-crisis was flaring up following Italian elections, along with fears that the U.S. Federal Reserve could wind-down its economic stimulus programs earlier than expected. Both concerns have since faded – which might explain the stock market rebound.

But what’s particularly interesting is the reaction to these market swings. The American Association of Individual Investors (via Bespoke Investment Group) showed in its weekly survey that bullish sentiment among small investors took a beating with the recent selloff: Bullish sentimet plummeted to about 28 per cent from nearly 42 per cent in the previous week – the biggest weekly decline in more than two years and the lowest reading since July.

“One unique characteristic of this bull market is the fact that there is very little commitment on the part of investors,” Bespoke said on its blog. “With the nightmares of 2000 and 2008 still fresh in their minds, these fair weather bulls are quick to head for the exits at the slightest hint of trouble.”

And all it took was a 3 per cent dip.

Barry Ritholtz at The Big Picture weighed in, wondering which was more irrational – markets, which jump all over the place; or the media, which hypes-up the action and the concerns driving it: “Let’s begin by noting both of these entities are self organizing collections of humans,” he said. “Irrationality is built into their essence.”

Yet, he seems to side with the markets: “Between the two entities, which are you more likely to believe – the one whose job it is to match buyers and sellers, or the one who is trying to deliver an audience to advertisers?”

Personally, I think media influence is usually overstated. The media largely reacts to what the market is doing – It’s soaring! It’s plunging! It’s doing absolutely nothing!

As for how markets react to news such as Italian elections or Fed comments, again, it seems largely driven by investor interpretations rather than media hysteria. After all, Benjamin Graham’s allegory to the markets was Mr. Market, not Mr. Media – and Mr. Market has been in a strange mood of late.

Follow on Twitter: @dberman_ROB

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