How Rational Are Markets?
Rational or Irrational? Efficient or Inefficient?
Those are questions that academics wrestle with, and individual investors need to come to terms with.
A classic example is what market action gets credited or blamed on. Yesterday's sell off was blamed on weak retail sales and Citibank's big loss and write down. (I have a quote in today's NYT article, Citigroup Loss Raises Anxiety Over Economy)
However, these events were well known by those people who were looking in the right places (like readers of this blog). So how were these events such a surprise as to cause a major dislocation?
It comes back to crowds getting the big picture wrong, and individuals identifying those instances. I call this Variant Perception and contrarian investing. Ironically, seeing the variant is relatively easy -- the harder part is in the timing. That's what technicals and market internals are for.
Wait -- Are you claiming that you are smarter than the markets?
No. What I am very specifically saying is that there are opportunities to be uncovered if you can identify where the crowd is wrong. It happens all the time. Yesterday's WSJ article on John Paulson's hugely successful bet against subprime reaping him billions is a perfect example. Its not that Paulson is smarter than the market, its that he identified where the market, as a whole, was wrong.
Last year on CNBC's Morning Call, I discussed why the Financials and Banks had a lot more write downs to go, and steer clear of the sector. (thanks for the hate mail -- it made me even more confident that was the right call) This wasn't me being smarter than the market -- but it was an identification of where the crowd was being too sanguine, too unrealistic -- in short, wrong.
Crowds consists of irrational, emotional humans. We are slightly-cleverer pants-wearing monkeys. We do very dumb things when pursuing the bananas. We have not evolved to understand capital market risk. We are optimistic by nature, and tend to ignore the negative, until its staring us right in the face and cannot be denied. Then, we (irrationally) panic.
Remember, markets consist of lots of people -- some ignorant, and some not-so-ignorant. The present market action can be described as the process of the ignorant and the uninformed becoming less so. Where it can become truly dangerous is when the crowd morphs into an ugly mob. Think Soccer hooligans. That's when things become ugly -- when the monkeys start flinging feces.
Now, for the really scary part: That last step has yet to begin . . .
>
Sources:
Citigroup Loss Raises Anxiety Over Economy
JENNY ANDERSON and ERIC DASH
NYT, January 16, 2008
http://www.nytimes.com/2008/01/16/business/16bank.html
Trader Made Billions on Subprime
GREGORY ZUCKERMAN
January 15, 2008; Page A1
http://online.wsj.com/article/SB120036645057290423.html
Wednesday, January 16, 2008 | 07:30 AM | Permalink
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Comments
I'm guessing the 'real fun' begins when the dollar/Yen trade drops below 100...
Posted by: Chief Tomahawk | Jan 16, 2008 8:18:50 AM
Transition from denial to anger..
Posted by: Stuart | Jan 16, 2008 8:21:02 AM
Rep Dingel on CNBC just said if gas prices come down it will undermine better gas efficency standards on cars
green energy falls in the same fight with oil
we need to design a work for benefits system - away from the 6000 year old cash dispersement standard
Posted by: Greg0658 | Jan 16, 2008 8:27:27 AM
Barry, you may be right this year with predicting another 10% drop in the SP...maybe in a couple of months things will have a better feel, but right now everything looks UGLY
Posted by: kurt | Jan 16, 2008 8:45:34 AM
One caveat would be that not all members of the mob are equal. Me, my buddies and the investment club in town are not equal to the MF, HF and sovereign funds. They are what moves the market.
Posted by: Mike | Jan 16, 2008 8:59:20 AM
It will be a 20% drop at least on the s&p 500. This is going to get real scary for alot of people.
On other point: I thought Dingel was positioning congress to hold or even increase gas tax as prices come down. Only good source of revenue that I can think of. The state coffers are really hurting.
Posted by: Justin | Jan 16, 2008 9:02:15 AM
I'm from and living in a particular country (Venezuela), so I'm able to analize US economy from an outside picture... I love finance and economy, following this passion I started trading in the middle of 2001's bubble. This exceptional period of time helped me to develope a contrarian thinking, and also to search new sources of reliable information...
Thanks to that search I found two blogs to read daily and intradaily using a great tool (netvibes):
http://bigpicture.typepad.com/
http://www.rgemonitor.com/blog/roubini
From here, I congratulate you and Prof Roubini for insisting in what points the mass (including many pundits) was wrong, fighting against the conventional wisdom. Today, the reality is giving you great credibility, something hard to find in these days...
Posted by: Henkel Garcia | Jan 16, 2008 9:07:00 AM
Hi Barry, If we can keep congress focused on baseball we may be able to get out of this financial mess with an additional 10-20% correction. People are finally beginning to get the picture you have been painting for the last 1-2 years. Thanks.
Posted by: David Price | Jan 16, 2008 9:15:53 AM
This is an important academic issue.
Economics has equated the statements
"There is no free lunch"
and
"The market is always efficiently priced"
However, they are not the same. The evidence is ever mounting that the market is not perfectly priced, but the academic question is - why then is so difficult to regularly beat the market.
I think that depends as much pyscho-social costs as it does on accounting costs.
Posted by: Karl Smith | Jan 16, 2008 9:25:19 AM
I think the Stock Markets would tend to function more 'Rationally' if the Federal Government showed more Fiscal Responsibility (i.e. reduction in trade and federal deficits) and the Federal Reserve adhered more to it's congressional mandate. Looking over Bernanke's opinions on the causes of the Great Depression, past testimonies before Congress, and recent operations of the Fed (think last August's little surprise...) I'm convinced he's further undermining the credibility of the Federal Reserve. Given that he was appointed by Bush, and that he seems to pander to the whinings of WallStreet, and more frequent speeches on his part regarding the Fed's 'economic positions' (to make the Federal reserve more transparent) are, in my view, factors that are going to continue to erode this credibility even further. Bernanke is not the guy we need at the Fed after Greenspans last four years. All we need now are some inter-meeting rate cuts...
Greed and Fear are always going to dominate the Stock Markets... that will never change... But Fiscal Responsibility/Discipline on the part of the Federal Government--- and not turning a Blind Eye to problems that should have been anticipated by a competent commander-in-chief and his economic team (problems directly attributable to the credit bubble, subprime mess exacerbated by lax lending standards, spending etc.) and a Federal Reserve that adheres more to a Paul Voelcker type of mandate-- one that is not easily swayed by politics-- would go a long way to restoring confidence in the Markets.
Posted by: John | Jan 16, 2008 9:35:25 AM
There's irrationality, and then there's insanity. The diligent observer knew something was grossly wrong with the system when people started buying properties that had "appreciated" more than 200% in a couple of years. If you suspect that the driver of the taxi you're in is hammered, you get out at the next red light, regardless of the neighborhood.
Posted by: Marcus Aurelius | Jan 16, 2008 9:45:09 AM
Baseball and Chocolate is what our Gov't is "investigating"........
Gotta Love that...
Ciao
MS
Posted by: MICHAEL SCHUMACHER | Jan 16, 2008 9:46:32 AM
Barry, I must beg to differ (unusual as I tend to agree with you mostly). What you are describing is lame attempts by the media to explain moves in the market that reporters, talking heads, and editors can't properly explain. The media is often/usually? late or wrong or manipulated by traders (think Cramer or Fast Money lipsters) but this is not variant perception as described by Steinhardt in his Market Wizard interview.
Anyway, enjoy the bear market. Cheers.
Posted by: lurker | Jan 16, 2008 9:49:38 AM
George Soros and Jim Rogers both made a tremendous amount of money by following some form of the Buddhist Maya principle.
"Everything which one sees in this world is illusion - a product of the individual's failed interpretation and self delusion."
Nothing is as it appears, sometimes there can be large discrepancies and its when those discrepancies become large, they become unstable. Most times the discrepancies are very minimal.
Posted by: Josh | Jan 16, 2008 9:50:45 AM
I know of no reason why the market should stop at 10 - 20%. Since the state of the American consumer is so poor, we can expect employers and state/local governments to tighten their belts, reducing expenditures along with income/taxes, increased layoffs. It's just a matter of time before that cuts into earnings, something that should happen relatively soon. Then the market tumbles. The public view on debt and lack of market regulation have brought us here and there's no do-over.
It looks like a very good opportunity for a lot of people to lose huge sums of money. But one thing I do know, is that in these situations the big players often get cooperation from the government and despite bad bets, they tend to thrive or at least survive. Witness the Countrywide/BOA deal--now we find out BOA will have billions in tax breaks for the next five years. What we need to be asking is, given the assumption that the Fed will be lowering interest rates, who benefits? How do they benefit? That is, what plays do they make on the market?
If the Fed lowers rates, that'll spur inflation and lower the value of the dollar. Is the Fed trying to make the big financial institutions' losses worthless? The new cash infusions by Sovereign Wealth Funds into places like Citibank are given in dollars, but since these are multinational corporations, could these investments be held in foreign currencies while the dollar tanks? That's another way to help Citi out of this mess.
The government and the big financial institutions work hand in glove; the former can't allow the latter to fail. So the fix is in. It may take time to get out of the mess, and it may take time to figure out exactly what they did. Anyone willing to speculate?
Posted by: Jay | Jan 16, 2008 9:54:51 AM
am beginning to wonder how rational the FOMC is having us stare into the abyss as we are now...
ralph
http://successfulonlinetrading.com/blogs/
Posted by: Ralph | Jan 16, 2008 9:57:12 AM
Barry - The problem with "rational" or "efficient" markets is that it's based on expectations of future events. Of course, nobody can know the future, but people will spend a lot of money trying to predict it, or form their own (quite possibly sanguine) gut feelings. Your implicit assumption of irrationality or ignorance has no place in this theory. Rationality is the only assumption that makes sense -- the "problem" is uncertainty of the future.
Posted by: get sum | Jan 16, 2008 9:57:19 AM
anutha Gap and crap......
Couldn't have predicted that........LOL
Ciao
MS
Posted by: MICHAEL SCHUMACHER | Jan 16, 2008 9:58:23 AM
One caveat would be that not all members of the mob are equal. Me, my buddies and the investment club in town are not equal to the MF, HF and sovereign funds. They are what moves the market.
I think you almost hit it on the head. I actually look for inefficiencies to show up in places where the big money is. The reason for that is because by their very size they can't move quickly without creating a self fulfilling prophecy. Therefore when news gets bad the little guy can move quickly towards the exits and the elephants will move deliberately towards the exits. They also have a vested interest in protecting their turf
Because the elephants can't move quick this is where the imbalances happen.
So my trading philosophy boils down to this
watch the elephants
keep watching the elephants
and
always watch the elephants
When they run you'll probably still have time to get out before they escape. It works even better on the upside. Where they are going there is plenty of grass and plenty of water. There needs to be or they would die. And you could live a long time on the meals they eat
So watch the elephants!
Posted by: DavidB | Jan 16, 2008 10:09:29 AM
And a great tool to watch elephants with is Investor's Business Daily.
Posted by: Mike | Jan 16, 2008 10:12:10 AM
If the markets are always right, why do they have corrections?
Posted by: Pool Shark | Jan 16, 2008 10:16:01 AM
This is why they are called "panics". People react irrationally out of fear when markets look bad and buy like maniacs when things are good. God love 'em.
With the emphasis on TV and in writing about recession and write offs, expect more fear and stampedes to the exits. You go!
Get rid of all the crap now so we can find a bottom and go back to the races. Hong Kong did a great job yesterday in degassing it's bubble. South Korea helped. Australia is working overtime and deserves another shrimp on the barbie. Japan is, as always, inscrutable. Brazil is the only large holdout. The US has only a little more to go, by my estimates.
Unfortunately, the return trip won't be a fast elevator ride up, I think. And I also think this summer will make a few investors vomit on the trip down, again.
Why? What you are observing is the marriage of economics and psychology. One partner is manic-depressive. The other is rational, boring, and wrong a lot. The business they own and operate is influenced by their relationship. The screaming lunatic spouse is the company president.
Posted by: cinefoz | Jan 16, 2008 10:17:48 AM
Step 1. Admit your not rational. At least not for the modern world.
Step 2. Admit that the market is an abstraction that's made up of millions of individuals that act on their own self interest, rational or not.
Step 3. Go read "Blank Slate".
From this point your on your own....
Posted by: Steve | Jan 16, 2008 10:35:50 AM
During a bull market we can all benefit from those persons shining light on ignored ills (e.g., the leverage in the last cycle). However, IMO dooms-dayers supply as little value to an intellectual discussion as eternal optimists who think things like dotcom stocks, real estate appreciation, China, and solar can grow exponentially in perpetuity.
I think it's been generally accepted by The Big Picture crowd that the near future has negative issues. SO, what say you about any seeds of positivity that are now being ignored by us?
Although bearish trades may be king for a while, they will not forever. And I think the value of this blog is seeing reality as it is so we can all profit (rather than simply repeating how f-ed up the system is and prophesizing the apocalypse like a fear mongering evangelist).
No matter how we feel about our system, it is what it is. Fiat money is simply paper, but people accept that paper for goods and services because, for the overwhelming majority, we have put our labor into the market for that paper.
Further, what dooms-dayers fail to recognize is that consumerism and entrepreneurism are core components of our CULTURE. Thus, they are intensely ingrained in our behavioral norms. One can even argue that these characteristics (of US residents and increasingly more of the globe) have taken on an air of religion. Consequently, no matter what type of recession we get, our conditioning to consume and create businesses WILL ultimately lead to recovery.
If it is true that by and large we are addicted to consumerism, then, like all addicts, we will find our next fix by any means necessary. With that said, is ANYONE interested in recognizing where we are now, outlining some basic phases of the recessionary cycle we face, and then throwing out some hypotheticals regarding what will drive the economy to recovery? I have already read enough books about the fall of the Roman Empire ...
Posted by: D H | Jan 16, 2008 10:39:01 AM
Markets sowing seeds of its own recovery...
OIL FUTURES: Nymex Crude Falls As Low As $89.90, Down $2Last update: 1/16/2008 10:33:29 AM(MORE TO FOLLOW) Dow Jones Newswires
Time to buy finance and consumer discretionary....
Posted by: Vermont Trader.. | Jan 16, 2008 10:39:18 AM
