The recent commodities sell-off has been breathtaking. This is especially true since the most-recent downturn occurred from a level where the expected future returns from commodity index investment were reasonably good – and, as a spread above expected equity or bond returns, probably around the best levels ever.

But investors have a strong tendency to use the current level, rather than some esoteric measure of value, as the level from which expected market moves are evaluated. What I mean by that is this: in theory, if some event happens in the capital markets, the reaction in the market should depend on whether that event has already been “discounted” in the current price. That is, if we are all expecting Microsoft to raise its dividend, then the price of Microsoft should reflect that change already, and when it subsequently actually happens it should have no effect on price. Indeed, if the market has overestimated the change in fundamental value, then the price of Microsoft should retrace somewhat when the news is actually announced. From that, we get the old saw that one should “buy the rumor, sell the news.”

The fact that this isn’t really what happens is not exactly news. In the early 1980s, Bob Shiller demonstrated that the volatility in the equity marketplace was much greater than the changes in the real underlying values should support.

In practice, investors don’t behave rationally. The same event can be discounted over, and over, and over again. Each investor, it seems, hears news and assumes the current price does not incorporate that news, no matter what has happened previously to the price. Based on my own unscientific observation, I think this is more true now that there are more retail investors, and news outlets that benefit from making everything sound like new information. If my supposition is true, one implication is that markets can deviate further and further from fundamental values. In other words, we get more bubbles and inverse bubbles than we would otherwise.