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 . . .   


Citigroup Loss Raises Anxiety Over Economy
NYT, January 16, 2008

Trader Made Billions on Subprime
January 15, 2008; Page A1

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What's been said:

Discussions found on the web:
  1. Chief Tomahawk commented on Jan 16

    I’m guessing the ‘real fun’ begins when the dollar/Yen trade drops below 100…

  2. Stuart commented on Jan 16

    Transition from denial to anger..

  3. Greg0658 commented on Jan 16

    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

  4. kurt commented on Jan 16

    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

  5. Mike commented on Jan 16

    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.

  6. Justin commented on Jan 16

    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.

  7. Henkel Garcia commented on Jan 16

    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):

    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…

  8. David Price commented on Jan 16

    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.

  9. Karl Smith commented on Jan 16

    This is an important academic issue.

    Economics has equated the statements

    “There is no free lunch”


    “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.

  10. John commented on Jan 16

    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.

  11. Marcus Aurelius commented on Jan 16

    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.

  12. MICHAEL SCHUMACHER commented on Jan 16

    Baseball and Chocolate is what our Gov’t is “investigating”……..

    Gotta Love that…


  13. lurker commented on Jan 16

    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.

  14. Josh commented on Jan 16

    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.

  15. Jay commented on Jan 16

    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?

  16. get sum commented on Jan 16

    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.

  17. MICHAEL SCHUMACHER commented on Jan 16

    anutha Gap and crap……
    Couldn’t have predicted that……..LOL


  18. DavidB commented on Jan 16

    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


    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!

  19. Mike commented on Jan 16

    And a great tool to watch elephants with is Investor’s Business Daily.

  20. Pool Shark commented on Jan 16

    If the markets are always right, why do they have corrections?

  21. cinefoz commented on Jan 16

    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.

  22. Steve commented on Jan 16

    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….

  23. D H commented on Jan 16

    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 …

  24. Vermont Trader.. commented on Jan 16

    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….

  25. cinefoz commented on Jan 16

    D H,

    It is even less complicated than that.

    1) Money needs a place to go. New money is always being created and being added to the amount of funds available for investment. It will always seeks the highest return perceived to be within the risk tolerance of the owner of the money.

    2) The number of things to invest in grows at a slower rate than the the rate of growth of cash available to invest.

    3) 1 + 2 = the potential for asset inflation, depending on the rate of growth of investment funds over time.

    4) Stability invites risk takers to take risks. This creates a bandwagon effect. Additional investors are attracted to the market. The value of assets rises due to demand for the asset PLUS increases in the supply of investment funds.

    5) Eventually, the market is perceived as rising too far relative to the perception of value. There is always a new reason for Why. Asset revaluations based on excessive asset inflation APPEAR to be massive drops because they rose far above long term expected values.

    6) Go to Step 1.

  26. cinefoz commented on Jan 16

    I said I was going to buy in at S&P 1360. Nope. Not today. It doesn’t feel right. There’s still more to go. But we’re close.

  27. Vermont Trader.. commented on Jan 16

    Very interesting action today.. Energy and materials keeping sp500 down. Retailers up. Financials Flat, Consumer Flat.. Dollar rallying, oil down.. Emerging markets down hard…

    A lot of stocks have been destoyed here… I see lots of good risk reward tradeoffs….

    All this market needs is a little leadership and a push and we are off…


    Short OIH, USO, XLB, EEM

  28. MICHAEL SCHUMACHER commented on Jan 16


    # 5 best sums it up. IT’s no coincidence that during the same time period the Cramer’s of the world were telling people to buy tech….not for a fundamental reason, technical reason or ANY solid reason….just to buy them. And they then beging to wonder why it starts to end poorly.

    Check out Dougie Kass yesterday telling people to “hold those financial stocks for 1-2 years”….the day AFTER he says to buy them because the “tide has turned”.

    From the looks of it we will add another name to the roll call of “where are they now?” in a few weeks time.


  29. Wayne Mulligan commented on Jan 16

    Markets efficiently incorporate information…but they don’t ACCURATELY price that information into stocks. I guess what I mean is that the market definitely moves with respect to all new information very quickly…so that information efficiently incorporates itself into the market as a whole. But the problem with efficient market theory is that it assumes the information is incorporated rationally and accurately.

    It was like when I was buying AXP back in 2001 – this company wasn’t going out of business but the stock was trading like it was (based on a number of factors, especially insurance exposure after 9-11). It was an efficient incorporation of information, but not an accurate one.

    As intelligent investors we have to use this efficient/inaccurate incorporation of information to our advantage to go bargain hunting!

  30. Stuart commented on Jan 16

    The markets are like a 5 year old child. Emotional, reactionary, not very rationale at all. ECB officials trying to jawbone the Euro down…not very rationale at all.

  31. Peter Davis commented on Jan 16

    The market is never efficiently priced. Never has been. Never will be. Why? Because what is an efficient price? The very definition is subject to interpretation.

    Academics fail because they believe in absolutes, but in the market, there is no such thing. Value and pricing are only what someone perceives them to be. Markets are not driven by some objective idea of value; they are driven by the collective mood of their participants.

    And given that people are rarely rational, markets therefore follow the same irrationality. This doesn’t mean that the market doesn’t exhibit predictable patterns that can be traded profitably.

    While I don’t feel that those who look for some definition of value have faulty methods, I do believe that those who try to ascribe the notion of value to the movements of the market are setting themselves up for a fall. Markets trade on psychology and psychology determines what the crowd feels value is. I don’t believe John Paulson was successful because he was right and everyone was wrong. I believe he was successful because he successfully predicted that the crowd would eventually come to the opinion that that the housing sector was overvalued compared to the prices being paid. In other words, he forecast a turn in psychology and the result that turn would have on asset prices.

    It’s not right and wrong. It’s perception and reality. There’s a big difference. One deals in absolutes; the other in relativity.

  32. D H commented on Jan 16


    I don’t think it’s less complicated than I stated, but I think our models work together. You are correct about the flow of capital, but there are countless examples where economies and markets languish because the culture is lacking consumer and entrepreneurial zeal. For example, European economies have tons of wealth creation, but the people have a different attitude towards buying the 1000th widget or working those extra hours. Hence their market performance versus the US before the dollar became toilet paper over there.

    A great future example is Thailand. I was in Thailand last year and have Thai friends. Although there is a lot of capital flowing their way, good luck changing the cultural attitude toward relaxation (Thais get a ton) and time (morning, afternoon, and night are fairly detailed marks of time — C.f. I will see you at 1pm sharp). Thus, I believe return on capital in Thailand will be far inferior to the US if we are measuring how much productivity we are getting per dollar spent.

    Regardless, assuming our models are talking about the US, IYO where will all the money go that needs a home? Right now it seems like gold and treasuries, but those don’t stimulate asset appreciation that will get the economy going again.

    BTW: I have greatly appreciated your comments and enjoyed the dialog. Feel free to email me as well.

  33. BD commented on Jan 16

    Barry: I enjoy your blog. Thanks for attending to the details.

    How much do you think monies that are relatively expensive to move out of retirement accounts are affecting the stock market? I mean there is a lot of money out there that is not ever going to be pulled out of securities as people have very little in the way of options and the penalties are so draconian.

    I just haven’t seen many discuss this topic and it seems like the whole retirement business means a certain amount of new capital flows into the stock market on any given month, automatically withdrawn from paychecks. Thus when the stocks go down, it’s *despite* all that new automatic inflow. It’s like stock inflation in many ways.

    And speaking of stock inflation, as businesses buy back their public stock, doesn’t that also mean fund managers have less stock choices or “supply”–more money chasing fewer publicly traded stocks? Thus a second “inflationary” pressure source on stock?

    Sounds like the potential for a huge over-valuation of stocks in general. Beyond that which may be caused by the larger market forces like this financial sector debacle.

    And if margin call is right around the corner…yikes.

  34. Bad home cook commented on Jan 16

    Nice quote in today’s NY Times, Barry. Congrats. You’re really somebody when the Old Grey Lady calls you for comment.

  35. Brett commented on Jan 16

    I saw what you were talking about with the ECB ‘jaw-boning’ the EUR down. Why would they do that while it is/was still sub 1.50? Wouldn’t they want to keep it right at that 1.49-ish level incresing their ability to buy up ‘shiny things’ over here that they like?

    On the same accord, there is talk of BoJ intervention on the part of USDJPY. Is that really in their best interest while above 103-ish?

    “Like a wookie on Endor….”

  36. Don commented on Jan 16

    Logic (i.e., rationality), as Oliver Wendell Holmes said, is not the life of the law. He could have said neither is it the life of markets, or for really any sort of human interaction.

    I think simple physics is a better prism than economics for understanding markets–what goes up eventually comes down. If it goes up a lot, it will come down a lot. I think Paulson saw that in real estate.

    For now, I’d say real estate will be a good buy in about mid-2009. Financials perhaps before. In the meantime, somebody is going to make a killing shorting gold.

  37. Elizabeth Harrow commented on Jan 16

    The financial sector is still getting too much love – witness the Bear Stearns upgrade of the whole group this morning. I can still remember last August, back when everybody thought that Q2 would be the “kitchen sink” quarter for bad news out of the investment banks. Do you think we’ve seen the worst of it yet with Q4?

  38. Francois commented on Jan 16

    “Now, for the really scary part: That last step has yet to begin . .”

    It’s scary if unprepared. With LEAPS puts in the portfolio, fear is replaced by greed.

  39. donna commented on Jan 16


    The first step to recovery is admitting there is a problem. I think the market has finally acknowledged that. Then we have to go through all those phases Barry discussed. Then we start to sift the ashes looking for signs of life, trying to encourage things to grow.

    How do we recover? Get rid of all these big piles of money that stink and spread them around. Break up the monster size dinosaur companies, and get those resources back out there being productive again.

    The rich and the corporate dinosaurs have had their fun. It’s time to start letting the mammals get bigger.

    In easier terms, look for the small companies that are doing well, and cast your dollars there. Help them grow bigger.

  40. ef commented on Jan 16

    EMH states that the price of a security is the sum of all public information. We are told the market is efficient by the current academicians. But in a pure sense, I don’t see how, for there are too many very wealthy insiders that have access to a lot more critical information and the power to use that information, compared to the general population throughout. Using stocks as major compensation in the 90’s skewed the hypothesis, w/CEO’s and others incentivized to pump and dump, at ordinary investors peril. Also, the general populace is lacking in funds, time, and credible information to cause a dent. Most people I talk to, highly educated individuals, great in their field, as well as blue-collar, are doing the dollar-cost average, buy-and-hold, into funds or indexes, until the day they retire. At which time, if they have an advisor, are being informed to dramatically change their asset allocation. Markets rational. Sometimes. But more so, not. Ignoring obvious headlines and data, is probably a little of both. That ugly crowd, will be baby-boomers wanting to save their retirement ;-| As far as the media telling us why the market changes, they are at a minimum story tellers. They get paid either way and have to prove their usefulness.

    Shown on Sundance Films this weekend:
    “The film follows U.S. Comptroller General David Walker as he crisscrosses the country explaining America’s unsustainable fiscal policies to its citizens.”

  41. socialman commented on Jan 16

    can you imagine what the monkeys will do when the credit card companies start terminating accounts by the thousands? where is the data on mailings and terminations?
    for Donna, right thinking but not Darwinian enough.
    Any organism with access to a rich supply of nutrients is going to keep hogging it all regardless of the benefits of distributing the opportunity for success more widely.

  42. badhaikuguy commented on Jan 16

    Somewhere back in the day I read a WSJ article about a chap (I don’t recall his name) who made a killing in options on currency futures. “I realized that the trick was recognizing the power of the Second Law of Thermodynamics”, he breezed. I found this to be an interesting take on the vagaries of the markets but had little idea what he was talking about so I decided to ask Lawrence McMillan what he thought this chap meant. McMillan said he had no clue – although he was probably being circumspect on purpose. So I pursued further definition on my own ( which is normally the best way anyway, n’cest pas? Turns out the Second law says that heat flows to cold – high volatility to low – big runups to big declines – greed to fear – and vice-versa. The elastic stretches and snaps back.

    Heat flows on to cold
    All is vain, no thing is fair
    Not a random walk

  43. Suge Knight commented on Jan 16


    That weed you smoke must be pretty good, would you mind sharing with us?

  44. Juan commented on Jan 21

    information is not generalized
    there is no perfect competition
    equilibrium is accidental

    price and value are not identities

    recognizing contradictions between the superficial and the real, between price and value, requires overcoming long-run beliefs provided by neoclassical economics and incorporated into finance theory.

    Barry is talking about the contradictions which develop yet go unnoticed by not only the crowd but most professional m. managers as well.

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