What moves stocks? Money managers' fear of getting fired

Jeremy Grantham, co-founder and chief investment strategist at Boston-based asset manager GMO GMO

(MoneyWatch) What is the single biggest factor driving stock prices? Conventional wisdom says earnings, or the European crisis, or Federal Reserve policy. But legendary investor Jeremy Grantham -- never one to follow conventional wisdom -- says the key driver is money managers' fear of losing their jobs. In his quarterly letter to clients, Grantham says this phenomenon is why the market fluctuates so widely even as economic growth stays in a relatively narrow range.

"The central truth of the investment business is that investment behavior is driven by career risk," writes Grantham, co-founder of Boston-based asset manager GMO. The prime directive among professional investors is "to keep your job," Grantham says, and the best way to do that is to "never, ever be wrong on your own." A great recent example is the tech boom: Money managers who recognized the bubble avoided tech stocks and so their performance lagged badly until the crash. The safer path was to go along for the ride -- sure they got creamed in the collapse, but so did everyone else.

As a result, professional investors pay ruthless attention to what other investors are doing. "The great majority 'go with the flow,' either completely or partially," says Grantham. "This creates herding, or momentum, which drives prices far above or far below fair price."

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There are plenty of other inefficiencies in pricing the market, but career risk is by far the largest. Most important, it explains how stocks can be so volatile even as the economy, as measured by gross domestic product, remains remarkably stable. See GMO's chart comparing the S&P 500 (red line) versus GDP (blue line) below.

GMO

The market moves 19 times more than is justified by the underlying economic engines, Grantham says, driven by career risk and a lack of long-term vision.

"Two-thirds of all corporate value lies out beyond 20 years," Grantham notes. "Yet the market often trades as if all value lies within the next 5 years, and sometimes 5 months."

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    Dan Burrows, a veteran of Aol's DailyFinance, SmartMoney and MarketWatch from Dow Jones, covers the markets and economy with an eye toward investing for the long haul.

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