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The Infallibility of Markets

Friday, January 26, 2007 | 07:24 AM

in Economy | Investing | Markets | Psychology/Sentiment

Yesterday morning's comments, The Message of the Markets, generated some interesting pushback. Felix at RGE, Abnormal Returns, and even here in comments. I got calls from people telling me why I was wrong, as well as people who said they would love to espouse those views but couldn't due to their employers (analysts mostly).

Let's expound on the idea a bit, and see if we can can't clarify the concept.

My main thesis is that Markets are mostly right. I try to hear what the bond market says; I closely pay attention to the equity market internals; When the Dow Transports confirm or diverge from the Industrials, I sit up and pay notice. Leadership, breadth, volume all contain some information.

The crowd is what drives stock prices, and they are the market. However, they are far from infallible and often get some things very, very wrong. And as we noted yesterday, Markets tend to be wrong at the worst possible time for those who are listening to what the Market is yelling -- but ignoring what the markets are whispering beneath.

And much to the consternation of momentum traders, the Markets tend to be "wrong" at the worst possible moments. Jim Welch detailed many of those instances yesterday. Let's add a few examples:

• In the Summer of 2005, the Home Builders were at their all time highs -- I guess the market was saying that Real Estate was not in for a major cyclical slowdown (wrong).

• Oil at $78 must have meant the economy was accelerating; And Copper at over $3? The same.

• In October 2002, I found many profitable, debt-free, tech and telecom firms trading for less than cash on hand. Mr. Market was telling you that a buck was worth only 75 cents.

• NYU's Nouriel Roubini likes to point out that the S&P rallied right into the teeth of the 2001 recession.

Market go up because the preponderance of the crowd are buyers, and they go down when they are sellers. But the deification of markets as forecastors of economic activity is simply a lazy man's cheat. The meme that markets are prescient forecasters of future activity is all too often accepted, unquestioningly and without thought.

Why are Markets frequently wrong? Because they are the product of the collective wills of emotionally unstable primates. We are slightly cleverer pants-wearing chimps. Our actions when we are part of a an unthinking herd have, well, herd-like consequences. Lemmings make for lousy investors, and primates ain't much better.

Markets can and do provide insight into specific activity -- but they can be, and often at the most impertinent times, spectacularly incorrect.

Those who follow Markets blindly, assuming them to be never wrong suffer the consequences of their folly.