Tuesday, August 23, 2011

Rational markets? Who says?

One of the things taught in finance classes is that markets are rational. The markets, students are told, price stocks based on their estimate of future earnings. News does not move markets unless the news is unanticipated for markets have already incorporated news that was expected. Students are also taught that markets are informationally efficient but there are degrees of efficiency. Weak form efficiency is when stock prices reflect only past information. Semi-strong efficiency is when stock prices reflect publicly available information. Strong market efficiency is when markets know all information both public and private. There is evidence that all have some truth associated with them - yes even strong market efficiency. However, recent events belie all notions of market efficiency. The markets move on reports of unemployment, inflation, consumer sentiment, oil prices, riots in Tunisia, Greek debt, French banks, if the Fed might announce easing or if the Fed does nothing. None of this can remotely be considered rational - especially in light that every knows the economic numbers will be revised. It is also interesting that the revisions do not move markets even though the initial numbers are always wrong. Consider last week when the Fed announced no policy change. The Dow fell by 200 points. Then when the statement was scrutinized, the word went out that the Fed had actually said that while it anticipated no change, that it had discussed the use of a wide range of tools. The markets immediately rebounded by 500 points. Such actions by professionals can only be described as irrational and put a lie to all that finance professors teach. Maybe its time to admit that the markets have a herd mentality and all those traders simply don't have a clue. By the way, most make their money by trading and not by the profitability of their actions. So just keep that in mind. Brokers get paid by the trade regardless of whether the stock goes up or down so if you are out there churning your stock along with all those professionals, your net return will be lower than if you simply bought and held. Its time for all to re-read Burton Malkiel's Random Walk Down Wall Street.


John in KY said...

Do you think the law allowing short selling without physical possession of the stock has something to do with the volatility?

H.A. Black said...

John, The honest answer is "I don't know". The evidence linking short selling and volatility is from markets outside the US. Most of the studies of US markets say that markets are more volatile (not less) in the absence of short selling so that short selling actually dampens US volatility. Markets that limit short selling turn out to be the markets with the most mispricing of stocks.