The aborted Pentagon futures market inspired skepticism about the idea that the collective action of investors predicts the outcome of events better than professionals can. Supporters of the market have been defending themselves by citing "decision markets" that work: orange-crop markets that guess Florida weather better than meteorologists or the presidential election markets that outpoll the pollsters.
But here's a great, important example that no one has mentioned, a case when the stock market solved a complex public conundrum far more quickly than the pros. After the January 1986 Challenger space shuttle disaster, a blue-ribbon commission chaired by former Secretary of State William Rogers spent several months investigating the crash. (A similar investigation board is now trying to get to the bottom of last February's Columbia shuttle explosion.) The Rogers Commission report, issued in June 1986, laid the blame squarely on defective O-rings in booster rockets produced by Morton Thiokol.
But in an article in the forthcoming September Journal of Corporate Finance—the abstract can be seen here—Michael T. Maloney of Clemson University and J. Harold Mulherin of Claremont McKenna College argue that the market figured out which company was responsible within minutes of the disaster, and calculated how much the disaster would cost the culprit in lost profits within hours. It's either spooky coincidence or the ultimate proof of the efficiency of markets.
The crash of the Challenger on the morning of Jan. 28, 1986, was both highly visible and a complete surprise to market participants. There were four highly liquid publicly held companies that were prominent contractors on the shuttle. Rockwell International made the shuttle and its engines, Lockheed handled ground support, Martin Marietta made the external fuel tanks, and Morton Thiokol made the shuttle's solid fuel booster rockets.
As the news broke, the authors write, the stock prices of all four companies fell anywhere from 2.83 percent to 6.12 percent in the 21 minutes after the crash. But trading was halted only on the stock of Morton Thiokol. "The fact that market liquidity was available to maintain a market in Lockheed, Martin Marietta, and Rockwell while the market for Morton Thiokol dried up suggests that the stock market discerned the guilty party within minutes of the announcement of the crash," Maloney and Mulherin conclude. By the end of the day—when the cause of the accident was still a mystery—Morton Thiokol was down 11.86 percent, while the other three contractors lost 2 percent to 3 percent.
Morton Thiokol shed some $200 million in market value on the day. Over the next several months—before the release of the commission report that singled out Morton Thiokol for blame—the other contractors recovered and outperformed the market while Morton Thiokol lagged. In other words, Morton Thiokol's stock "acted" like it was at fault.
As a result of the investigation, Morton Thiokol had to pay legal settlements and perform "repair work of $409 million at no profit." It also dropped out of bidding for future business. Add it up, the authors conclude, and "the $200 million equity decline for Morton Thiokol seems in hindsight to have been a reasonable prediction of lost cash flows that came as a result of the judgment of culpability in the crash by the Rogers Commission."
At first blush, the action of Morton Thiokol's stock would seem to be a ringing affirmation of market efficiency—the notion that stock prices quickly and accurately respond to new information. But the authors correctly don't take this to mean that we should scrap commissions and instead simply look at the tickertape when disasters involving publicly held companies occur. After all, Maloney and Mulherin still can't figure out why the market knew to blame Morton Thiokol. It doesn't seem to be insider information, but they don't have any other good explanation. They conclude, quoting Maureen O'Hara (the Cornell economist, not the actress), that this may be a "perplexing situation that while markets appear to work in practice, we are not sure how they work in theory."
What's more, a look at the initial stock-market reaction to last February's Columbia disaster—discussed in this Boston Globe article—reveals that the market's response wasn't quite so rational. On Feb. 4, 2003, among the publicly traded NASA contractors, the biggest loser was Alliant Techsystems Inc., the current owner of Thiokol, which made the shuttle's booster rockets. Alliant's stock fell almost exactly the same amount that Morton Thiokol did on the previous crash—about 11.66 percent. Boeing, which now owns Rockwell International, a major NASA contractor, fell 1.5 percent, and Lockheed Martin fell about 3 percent.
The market—perhaps remembering Thiokol's implication in the prior disaster—swiftly punished Alliant. Wrongly, it seems. Thus far, attention has focused on the performance of foam insulation lining the external fuel tanks, which were made by the Michoud unit of Lockheed Martin.
The market may be efficient. But it can also (economists, avert your eyes) be emotional. Did traders with long memories rush to sell Alliant disproportionately because Morton Thiokol was deemed responsible for the Challenger disaster? Almost certainly.
We live in an age when information is disseminated more broadly and rapidly than ever before, and when more investors have the ability to act on that information than ever before. As a result, the market tends to overreact to news events. The markets may provide a reliable play-by-play, as they did in 1986, but we still need a detailed box score—compiled after the fact—to confirm what really happened.