The Infallibility of Markets

Yesterday morning’s comments, The Message of the Markets, generated some interesting pushback. Felix at RGEAbnormal 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.

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What's been said:

Discussions found on the web:
  1. toon commented on Jan 26

    — Why are Markets frequently wrong? —

    Wrong question.

    Markets are frequently right.

  2. curmudgeonly troll commented on Jan 26

    Markets are great, the best forecasters we’ve got.

    But the free-market fetishists like to pretend that they’re perfect.

    More money for us curmudgeonly cynics.

  3. Macro Man commented on Jan 26

    “Markets” are neither right nor wrong: they are simply an aggregation of individual security or asset prices, which themselves reflect supply and demand for the securities or assets.

    The investment decisions that shape those prices can be right or wrong, and there’s a very simple way to see: P/L.

    To take an extreme price just before an immediate reversal and claim that it is “wrong” is a pointless exercise, in my view; anyone can do that ex-post.

    For example, the points above:

    * New home sales reached their peak in September 2005. Is it particularly surprising that the builders were at their highs a few months before? In fact, homebuilders started to sell off before new home sales peaked.

    * I am not aware of a barrel of oil, or any economist either, who suggested that $78 oil was indicative of an accelerating economy. I know of plenty who suggested that $3 gas presented a negative income shock. I am also aware that a number of peope, who were bearish oil at $78 were also bearish at $68 , $58, and even $48.

    * Point three represents a successful investment decision that followed fromn other people making unsuccessful investment decisions.

    * Mr. Roubini knows a thing or two about being wrong. Not only has he badly underestimated the resilience of the US economy, but his joint forecast of a US recession, a weaker dollar, and a widening current account deficit are more or less mutually exclusive.

  4. Lauriston commented on Jan 26

    IMHO, I think the markets don’t forecast, but they reveal current sentiment or how much liquidity there is or is not in the system. Casinos forecast nothing, they just reveal how much people are willing to gamble/risk. In good times, gamble more, in bad times, less. But many people are affronted at the suggestion that markets are casinos, so vendors/economists/scholars prefer to ruminate on how markets and the future can be linked, all with their own profit motivations. And you know what the Chinese say about scholars!

  5. Mike M commented on Jan 26

    Markets are wrong all the time. But doing anything about it is very, very difficult. That’s why most don’t outperform the market.

  6. Philippe commented on Jan 26

    If the question is
    Are the equities markets a leading indicator of economic cycles on their own ? The answer is no.
    Are they incorporated in leading indicators models?
    The answer is yes as one of the component of economics agents expectation..

  7. lurker commented on Jan 26

    I thought the markets were a pricing mechanism and a very emotional and liquidity driven one at that…in fact, if prices were always correct and correctly predicted the future all traders should hang up their charts and hand over their money to Vanguard index funds for safekeeping with low fees. Fun discussion, but rather silly.

  8. DavidB commented on Jan 26

    How about if you clarify it for them then? The bottom 75% of the adopters in the crowd is usually wrong in the extremes. Those are the ones that are usually buying from the first 25% of the adopters while those 25% are off looking for other things to eventually sell to them

    Inertia has a lot to do with the whole movement at the point of extremes

  9. saltwater commented on Jan 26

    Keep up the good work B! In 2006 my client returns may have under performed the market HOWEVER, our risk level has been exponentially reduced. That is the value added service I appreciate as do my clients.


  10. Emmanuel commented on Jan 26

    It would be good to state which markets we’re speaking of here–there’s a difference. In terms of cred, I’d rank them this way though your rankings may vary of course:

    Foreign exchange

    Several studies have demonstrated that the last two often follow a “random walk” pattern. So there you are.

  11. Eric commented on Jan 26

    “We are slightly cleverer pants-wearing chimps”

    After reading the 101 dumbest business moves of 2006, I am convinced that you may be slighly over-estimating our cleverness…Although most of us do wear pants (with the exception of the guy sitting outside my office today).

  12. js commented on Jan 26

    That the bond market does a better job at forecasting economic conditions is a thing of the past. All through this cycle, it has underestimated the Fed (which is saying something given that the Fed has been super slow at tightening). Morevover, it has priced in recession or growth recession 4 or 5 times in the past 3 years. All wrong. The latest is another example. The stock market has gotten it right (so far). It might be the presence of price insensitive central banks or oil exporters. But the fact remains that the fixed income market has handed a bunch of shrewed investors big losses in the past 3 years because of its irrational behavior in continuing to look for growth shortfalls.

  13. Philippe commented on Jan 26

    Fine then please read the 102nd dumbest financial maneuvers:

    In 2005 a programme of debt services was in force private or public endeavour?, since they are no sanctions on the culprits, since the firing of City bank bonds dealers in Frankfurt was motivated by a forceful selling of bonds ie driving yield higher price lower and looked like “a coup d’état” since the world bonds markets were following the same pattern I guess it was “a raison d’état”
    A programme of assets price maximisation is in place stock markets
    Same scenario natural longs are involved, graphic operators at ease, press involved and all the finesses of finance in butressing profits, statistics are dubious and long term yields pent up justified.
    Even the leading indicators of OECD are involved jacking up the industrial component of the indicators, the stock market is a sentiment indicators, the moral des menages, IFO ZEW Customers confidence are good too good. The yield curve is rebalanced and soon the truth will come the reflation is over or may continue if they are still stocks sellers or short sellers to feed the markets.
    This manoeuvers have involved too many insiders not to defeat the guilt of being an insider, the rest are part of the 103 dumbest thing in the world of finance.

  14. Francois commented on Jan 26

    This is so easy: If Market truly had forecasting ability, anything based on contrarian analysis could not ever be right.

  15. scorpio commented on Jan 26

    you know the old saying about 1000 chimps banging away at the typewriter: while they may trail the market, over time they’ll beat the average money manager. and that kind of confidence means you can get away w anything. hence, no pants.

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