Stephen Dempsey is an associate professor of accounting in UVM’s School of Business Administration. His teaching and research interests include corporate accounting policy, financial statement analysis and the effect of income disclosures on stock market behavior. In addition to his research in these areas, Dempsey has been working the past several years developing and implementing a national income-based performance measurement system for the U.S. Postal Service.


The past year has been a very unsettled period for the stock market. What do you see as the key factors that go into creating this sort of volatility?
There are probably two or three important factors at play. The first is just plain uncertainty about the general economy and uncertainty about where the fast-paced changes in technology are going to take us. The many different, sometimes contrasting, signals confronting investors lead to different perceptions about proper stock prices. Because trading is basically about optimists buying from pessimists, the extent to which their views differ has an impact on day-to-day price movements. Of course, if the two camps are widely polarized, then price fluctuations can be extreme.

A good example we’ve seen recently is Internet stocks. Many have been suggesting that these stocks are way overpriced by historical standards and that a “correction” is imminent. But if there’s another large group of traders out there that thinks the Internet will completely change the way we do commerce, then they might feel current prices are justified by long-term earnings prospects. It’s just a matter of very different beliefs about where and how much future earnings are going to be.

A second reason for volatility has to do with “liquidity” pressures. Individual investors are now playing a very significant role in the market due to things like defined contribution retirement plans and increased access to information and trading technology. With the large amount of money that’s flowing into the market and the ability of individual investors to direct the force of that money nearly instantly via computerized trading, you can see some wild swings.

Related to this is the effect of investor psychology. A lot of individuals are not necessarily “informed traders” and they can, for purely emotional reasons, affect mood swings in prices. Some of this has been documented in terms of “overreaction” of markets. Research finds that markets tend to overreact to news one way or the other if the news is significant.

What about the influence of world events such as the health of Boris Yeltsin or President Clinton’s situation?
Events of this sort certainly have an effect on the markets, but the degree of effect is often too large to be rational on economic grounds. The president, of course, is simply not the central economic force in our system of government, yet the market sometimes acts as if he is. In terms of the current Clinton situation, you could predict a market downfall as soon as the Lewinsky matter broke. But why? And then you have things like the president’s confession of sin at that prayer breakfast meeting causing the market to shoot up, and you wonder how this could possibly be rational market behavior. To explain those sorts of things is difficult to do. Really, on a macro sense, the economy is like a billiard table. There are a lot of balls on that table, and hitting one of those balls can have a profound affect on the positioning of all the others. But you can’t necessarily predict where they’ll all end up.

We’ve been particularly influenced by global crises recently. I think it’s very hard for most Americans to know how something like the southeast Asian crisis will influence their lives.
Again, the billiard table is a good analogy. Our economy, the southeast Asian economies and the economies of Latin America are all interdependent. But it’s very difficult to interpret the end result. For example, a lot of people were saying that the plight of Russia shouldn’t really have a big impact on us because their economy is so small, only $900 billion or so. The total Russian economy is about the size of the Netherlands, and their total market capitalization is less than half the size of Microsoft Corporation. So, yes, Russia is insignificant from that standpoint. But when you consider that you’re still talking about a military superpower here, a country with nuclear warheads, its economic instability is not limited to its own well-being. It very much affects the rest of the world’s health. You can’t discount Russia.

What are your thoughts on the Asian crisis?
Philippines, Indonesia, Korea, Japan … all of these economies are experiencing their own unique woes. Many of the problems are brought on by ill-functioning markets. The corruption, cronyism and nepotism in some of these countries has to be addressed. You have to make the economic system consistent with the political system—they have to work in concert. Democracies don’t function well with centralized markets, and free, well-functioning markets cannot coexist with corruption and cronyism.

Japan’s problems are somewhat different. The banks are the primary source of capital and they are really the primary “stockholders” in Japan. Unfortunately, this makes for an inefficient allocation of capital since the collective wisdom of a larger market isn’t at play. The banks have to clean up a mess of bad loans and are undergoing restructuring. Many think Japan’s on the rebound now after nearly ten years of stagnancy. But its economy is a huge mass, and when you have to move a huge mass it takes a lot of time.

Do you think Americans will feel the impact more through the trade disruption or the potential effect on other economies?
I think most are concerned with contagion, the “domino effect.” Of course, the Asian problem gives rise to the Latin American problem because Latin American countries are exporters of commodities such as basic metals. So their well-being is tied to the well-being of Asia and, of course, ours is too.

So, what we have here is very confusing to try to sort out or predict. But problems like these are in a sense good. It’s always cleansing to have problems like this; I even look at the presidential situation we’ve been through as a kind of cleansing process. It’s good to go through because you have to pay attention to causes, and then you can correct them. So, these countries, I think, will start improving their economic systems so that they’re more compatible with growth and global capitalism. In Europe it’s happening right now. From what I read Europe is really poised for good things in the future.

Will they be competitive with the U.S. in the near future?
Yes, I think so. The eleven countries that make up the union are about the size of the U.S. and their combined economy is about the same size also. With the Euro there will essentially be no barriers to trade. This reduces transaction costs because firms don’t have to be concerned with all the currency exchange rates and the losses they might take. Earnings in Europe are growing at about 21 percent compared to our earnings growth rate of about 5 percent. A lot of the things that served as our growth fulcrum in the 80s the restructurings, mergers, and the like are taking place there now.

So, an investor might want to consider investing in Europe?
I think that it’s probably wise to invest there. It’s always wise to diversify internationally as well as across different sectors of the economy.

In the face of all the volatility of the market, what’s your advice to investors who are investing for the long term to fund their retirement?
Volatile markets are only volatile in the short run. As you take a longer term perspective, volatility becomes less and less of an issue. When you have volatile markets you should just stay put, stick to it for the long run. Consistency outperforms shrewdness, if you define shrewdness as trying to make a bunch of short-term plays in a long-run period of time.

Investors need to make a self-assessment of how much risk they can bear and you can bear a lot of risk if you keep your computer turned off and the news turned off when it starts talking about markets.

History is a good teacher because it’s remarkably stable. What does history tell us about stock market performance? The average rate of return since 1926 has been about 11 percent for large firms and 13 percent for small firms. In that period there have been about as many bull markets as bear markets (about twenty-three of each). The average bear market is a decline of 25 percent, it only lasts an average of nine months and then quickly recovers an average of 36 percent.