The Message of the Markets

I have said in the past to "Beware the Economist who is seeking guidance from the stock market as to the state of the economy. These creatures make lousy economists and worse money managers."

Jim Welch takes this a step further, explaining the "message of the markets:"

"Over the many years I have been following and learning about the economy and financial markets, I have heard comments used repeatedly by presumably knowledgeable experts as they discuss various markets. People will say the markets are a discounting mechanism, and that markets anticipate events, as when stocks bottom before an economic recovery. Some people will go so far as saying that a particular market is telling us a specific outcome is coming based on how that market is trading.

After listening to these comments when I was younger, I too believed that “markets” were indeed imbued with a special instinct about the future. If I could just learn to listen to them, I would learn something I wouldn’t get out of a financial newspaper or research report. One of the CNBC anchors has even published a book entitled “The Message of the Markets”. Of course, the message is always clearer with the benefit of hindsight. I know I would have done better in school, if I could have just taken all those tests, after having already taken them once!

In 1982, the stock market had spent 16 years going nowhere, which prompted Business Week to publish a cover story entitled “The Death of Equities.” Somehow they didn’t get the market’s message that a 1,200% increase in 18 years was about to commence. When the stock market crashed 22% in one day in 1987, almost double the decline on Black Tuesday in 1929, was the market telegraphing a coming depression? And when the Nasdaq zoomed past 5000 in 2000, was it proclaiming that we had arrived in a “New Paradigm” Paradise? A list of examples showing that markets are always wrong at important turning points could be a very long list.

Needless to say, I don’t subscribe to the notion that markets ‘know’ much about the future. Markets are a reflection of recent trends and what a majority of investors have come to believe at that moment, in response to the recent trend. And, when a majority of investors are fairly certain of an outcome, the probabilities rise that something other than what is expected is likely to occur."  (emphasis added)

-E. James Welsh

We have said this previously, but it bears repeating: The crowd is right much of the time. However, the crowd can easily become an unthinking mob. They tend to be wrong at the worst possible moment, most especially at turning points.

Good stuff. Thanks, Jim.

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  1. Caravaggio commented on Jan 25

    Interesting article, but I think James Welsh’s view of the markets are a little too jaded. His greatest mistake, I believe, is not to discriminate between markets. For example, while all financial assets are priced by effectively discounting expected future cash flows, the stock market has a less direct relationship to expectations for the economy than, say, the fixed income market (government bonds). The information content in the yield curve surely tells us more about the economic future than any measure of the Dow or S&P. And then there are markets in even more direct measures of the economy, such as the relatively new economic derivatives that are traded through the CME, albeit on a very short tenor.

    Lastly, isn’t the point about crowds being wrong at turning points just a truism?

    PS – I believe the crowd (mkt) is wrong nearly all the time. Unfortunately, I have little idea about what is right, and whether and when the market will get there.

  2. David commented on Jan 25

    Surprisingly, I think, the American Association of Individual Investors ( sentiment survey saw a significant decline in the bullish reading for the period ending 1.24.2007. The reading this morning shows bullishness at 39.51% versus the prior week’s reading of 57.58%. I do not know an indicator that works on a standalone basis, but….

  3. OldVet commented on Jan 25

    Old Crazy Cramer had an interesting interview with Tim Russert last week, one on one. One of the things he told Russert was that about 100 top people control some $5 trillion and could decide which way the stock markets went. Maybe talking about the “crowd” is really talking about that 100 people, who normally move in concert through program (automated) trading.

  4. Philippe commented on Jan 25

    They are two types of markets:

    The lenders (Bonds)
    The buyers (equities and other markets such as commodities)
    The lenders tend to be more cautious about the quantitative background be it macroeconomics or financials (present or future).
    As regards the equities markets, they do not look at macroeconomics every day; they circle in their own markets models when they have one.

    When it comes to take the equities markets as proxies for macroeconomics models.
    Today’s economic situation is a case to remember leading indicators are pointing towards “slow growth”, economists are debating recession versus stagflation versus less growth; the equities markets worldwide have already borrowed in their share prices this year of profit (Swiss market today +6% in a month)

    It could mean that they foresee future economics uncertainties and discount it through actual prices or that they see nothing but present capital gain, or that short sellers make it a compelling obligation to climb up the ladder or the rebalancing of the yields curves require few market participants to avoid a stock market crash.

    The last but not the least who would like to have as a judge or as a proxy, a party whose mantra is that « he can be irrational much longer that you could withstand it »?

  5. Fred commented on Jan 25

    Interesting article…thanks.

    For me it’s how the various markets (equity, bond, currency, commodity) REACT to the macros….price is the final arbiter. This reaction is a function of the collective psychology. This is not always “readable” from sentiment indicators either. I find it a juggling of data, common sense, and the ability to see past the obvious (priced in) factors.

    Is that a “gut feeling”? :o)

  6. Patu commented on Jan 25

    in the last year, there was more money to be made with the crowd without a doubt. But who is the crowd? not the vast majority of market players in the last six months(other than the always fully invested mutual fund managers). No doubt it has been the oil ministers putting all that recent new found liquidity somewhere like the stock and bond markets. Surely they are not crowds but they have moved the markets in the last year to all time highs on the Dow. Maybe the definition of crowds is disingenous and misleading in the least. best regards friends.

  7. jm commented on Jan 25

    The crowd is right most of the time because the stock market is influenced by a combination of positive and negative feedback paths that make it analogous to certain electronic oscillator designs. In such electronic oscillators, rising output voltage feeds back to the input so as to induce even greater rise (vice versa when falling), and keeps on rising until it finally bumps up against some external constraint. Since it cannot then rise any higher, the positive feedback to the input disappears, the output begins to fall, and then continues to fall until it again hits some external constraint that sets a lower bound.

    In asset markets, the upper bound is usually set by a combination of prices rising to levels only a fool would pay, followed by exhaustion of the supply of investment funds in the hands of fools.

    Because the crowd itself creates the booms and busts through the positive feedback effect, it is by definition right — until the external constraints are hit.

  8. Teddy commented on Jan 25

    The money supply of most of the world’s currencies are up dramatically with a lot of it due to mercantilism, many countries trying to keep their currencies weak against the dollar. And why do they feel that trade surpluses are good?

  9. Lauriston commented on Jan 25

    Interesting article and comments, especially from OldVet. I hope we continue arguing and disagreeing about this topic, because that is what makes the market. If we ever figure out anything certain about the market, that will be the day we can kiss the market goodbye.

  10. Bob A commented on Jan 25

    There are moments when the crowd is thinking…. but when that happens, they are usually thinking something that’s entirely incorrect.

  11. Fred commented on Jan 25

    Put Call > 1 all day…I look for a reversal this afternoon (crowded put buying)

  12. Anil Passi commented on Jan 25

    Interesting article indeed, I always tried thinking on those lines, but I never reached any firm conclusion.

    Markets do try to adjust/track to future, but who can see the future accurately?? 20years from now, who can guarantee that likes of google, intel, sony, SAP or Oracle will even survive??

    I find the markets to be efficient for most period, and inefficient for smaller periods. The bulk money is made by recognization of inefficient periods in the market.

    My 2cents,
    Anil Passi

  13. ac commented on Jan 25

    Called that yesterday. Easy sucker’s rally that a experienced market man could see. I think the Bears just got taught when a real sucker’s rally happens.

  14. Fred commented on Jan 25

    Bernie Schaeffer has an interesting piece on He has provided a chart of the Fidelity Select Money Market Fund (FSLXX).

    ” During the past nine months, assets in this fund have spiked 125% higher to more than $2 bln, an all-time high.”

    “this is not “CD money” – it is “un-invested aggressive equity fund money.”

    This means the individual investor, who left the market in ’02-’03 has not returned to equities.

  15. RW commented on Jan 25

    Schaeffer’s analysis on Minyanville doesn’t appear responsive to the evidence he himself provides; in fact the evidence more strongly supports his counter argument which even then does not fully account for the 125% spike in the past 9 mos; that spike would appear to more strongly support the argument that those who left the market in the Spring of ’06 (not ’02, ’03 or ’05) have yet to return.

    One could certainly assume these investors consider the ’06 Summer rally unconvincing and/or providing a poor risk/reward ratio I suppose but the notion of “cash on the sidelines” as a bullish sign never made much sense to me so Schaeffer’s argument would probably have left me cold anyway.

  16. HVH commented on Jan 25

    Since Schaeffer only looked at Fidelity, he didn’t see me, but I went from 95% equities to 99% MMF last fall. I wouldn’t call myself “aggressive”, but I’m sure not getting back in until after a major correction. As RW says, the risk/reward ratio has been poor, and worsened in the past few months. I can live with some opportunity cost–it’s better than running for a too-narrow exit when the fire alarm sounds.

  17. samuel commented on Jan 25

    And Schaeffer’s track record of macro calls over the past few years has been quite poor.

  18. The Big Picture commented on Jan 26

    The Infallibility of Markets

    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 some people telling me why I was wrong, as well as people who said they would lov…

  19. Fred commented on Jan 26

    The wall of warts and worries is quite tall and long.

    That money will be deployed at higher prices, imho.

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